U.S. tax law can theoretically impose income tax on every type of income you earn. However, every taxpayer is entitled to certain reductions to their gross income in calculating taxable income. Your paycheck reflects some of the available deductions by providing a different figure that's sometimes called federal taxable gross income, but your actual taxable income is usually even lower than you're your paycheck says. Below, we'll look at some of the calculations involved.
What your gross income is
Gross income includes all the money you make, whether it's from your job, interests in a business, investment income from your portfolio, or pension and retirement income. The gross income on your paycheck obviously includes only what you earn from work, but on your tax return, you'll typically have to include income from all other sources as well.
However, if you look at your paycheck, you'll see that the federal taxable gross number is usually lower. That's because some of the money you have withheld from your paycheck isn't subject to tax. 401(k) contributions are one example, because they use pre-tax dollars to fund your retirement account. Similar provisions apply for health insurance premiums, flexible spending accounts, health savings accounts, or certain other deductible items.
Going from federal taxable gross income to taxable income
You might think that the federal taxable gross figure on your paycheck would be the number on which your taxes were calculated, but most taxpayers are entitled to other tax breaks that reduce their taxable income even further. IRA contributions, interest on qualifying student loans, and a host of other tax breaks are available to claim on your 1040 tax form.
If you elect to take the standard deduction, it can reduce your taxable income by thousands of dollars. Those who are eligible to itemize their deductions can sometimes get even larger reductions to taxable income by claiming tax breaks for mortgage interest, state and local taxes, charitable contributions, and certain medical expenses.
On top of those deductions, taxpayers can claim personal exemptions for themselves and any dependents that they're eligible to claim. For your 2015 return, each personal exemption you claim reduces your taxable income by $4,000.
Once you've subtracted all of these deductions, what's left is your taxable income. You can then plug that number into the IRS tax table or use other methods to calculate the tax you owe.
Gross income is a useful number to know, but it almost never reflects what you pay taxes on. Only by considering all the deductions available to you will you get a good idea of your true taxable income.
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