Intro to income tax

How is your income tax determined?

Computing your income tax is a multi-step process. Here is a general overview of the steps.

• Step 1: Subtract above-the-line-deductions from your total income to determine your adjusted gross income.
• Step 2: Subtract below-the-line-deductions from your adjusted gross income to determine your taxable income.
  
• Step 3: Your taxable income is used to calculate your federal income tax.

Definitions of terms

• Total income: includes salary, other income, interest, dividends, capital gains, retirement plan distributions.
• Above-the-line-deductions: include certain retirement contributions and health insurance deductions.
• Adjusted gross income (AGI): Determines how your income is taxed and your benefits from certain itemized deductions.
  
• Below-the-line-deductions: Standard or itemized deductions (e.g., medical expenses, mortgage and investment interest expenses).

Things to consider

You can’t avoid paying taxes, but you can better understand them – and minimize their impact where you can.

• Determine your total income and how to reduce your taxes on that income. (For example, contribute as much as possible to an employer-sponsored retirement plan.)
• Work with your tax advisor to understand whether you are required to pay estimated tax payments quarterly.
• If you receive a large refund, adjust your withholding or estimated tax payments so you have more money in an account earning interest.
• If you are going to take out a large loan, or make a big investment, discuss the tax and cash flow implications with your financial team and tax advisors.

Tax terms

Should you itemize deductions?

Generally, you’ll want to itemize if it will allow you to deduct more expenses than the standard deduction — which is a fixed amount generally based on your filing status.