How Does the IRS Calculate Your Income Tax?

If calculating your income tax ever felt like an unsolved mystery, it's time to unlock the code and eliminate your concerns -- especially since taxes aren't going away. Here are some steps to show you how the IRS calculates your income tax so you'll have more control over how much you pay when you file your taxes. 

Start with gross income 

Your gross income is the starting point for calculating your income tax. Although it's tempting to only put wages and salaries in this category, you also have to consider income from business, interest, dividends, capital gains, and retirement, just to give you an idea of other popular sources of income. 

IMAGE SOURCE: GETTY IMAGES.

Fortunately, your gross income is not the final number you are taxed on. The IRS rewards you with various credits and deductions that will reduce your income and allow you to pay less in taxes. 

Make adjustments to your income 

It may sound too good to be true, but the IRS allows you to legally adjust your income. You can claim "above the line" deductions that will help you arrive at your adjusted gross income, or AGI. 

Take note of some popular adjustments you can make to your income: 

• Educator expenses
• Student loan interest
• Qualified retirement contributions (i.e., traditional IRA)

Reduce your adjusted gross income by deductions to get taxable income

You'll have to choose between the standard or itemized deduction. The standard deductions are better than ever since the implementation of the Tax Cuts and Jobs Acts of 2017, so you'll find more people ditching the itemized deduction in favor of standard deductions that are nearly double what they were before.

While standard deductions are a pre-determined amount based on filing status, you have to do a calculation of qualified itemized deductions to determine what you can deduct on your tax return. Itemized deductions include certain medical expenses, charitable contributions, and home mortgage interest. 

Apply the tax brackets 

The federal tax brackets will guide you on your quest to determine how much you are taxed on every additional dollar of income you earn (i.e., your marginal tax rate). 

Don't fall for this common trap: believing that all your income is taxed at one rate. That's not how it works. If you had $50,000 of taxable income in 2021 as a single filer, you're going to pay 10% on that first $9,950 and 12% on the chunk of income between $9,951 and $40,525 and so on -- this is how marginal tax rates work for everyone, regardless of how much money you earn. 

Data source: IRS. 

Good news: If you are an investor who has held your stocks for over a year (long term) before selling, you get to unlock long-term capital gains tax rates of 0%, 15%, and 20%, subject to an additional 3.8% net investment income tax for higher earners. 

Take credit where credit is due 

Credits are the dessert of the tax return -- reducing your income dollar-for-dollar to decrease the amount you pay in taxes. They come in two flavors: refundable and nonrefundable. Unlike a nonrefundable tax credit, a refundable tax credit can lead to a boost in cash that's more than what you owe. If your tax bill is only $1,000 and you receive a $3,000 refundable tax credit (i.e., EITC), you walk away with a $2,000 refund.  

Some of the most desired tax credits are: 

• Child tax credit
• Child and dependent care credit
• Earned income tax credit 
• American opportunity tax credit 
• Lifetime learning credit 
• Savers tax credit (retirement savings contributions credit) 

The final bill 

Your IRS forms (or your tax software) will have you subtract what you've paid in taxes throughout the year from what you owe. If you paid too much money, you'll get a tax refund. If you didn't pay enough, you'll owe the IRS.

Knowing how the IRS calculates your tax bill is valuable information to have. Now, you can reduce your tax bill in strategic ways so you can keep more of your hard-earned money in your pockets.