Tax Basics: What's Your Tax IQ?

Key Points

  • Whether or not you do your own taxes, it's important to have an understanding of the basics.
  • This knowledge can go a long way in helping you use tax software or talk to a tax professional more knowledgably.
  • You don't have to be an expert but the more you know, the more confident you'll feel that you're not paying more than you owe.

Dear Readers,

It's tax time again and I'm getting lots of questions, especially from young people facing tax bills for the first time. Understandably, they want to know how they can reduce their taxes. And I'm glad they're asking because, while it's easy to rely on tax software or have a professional do your taxes, I think it's important to have an understanding of the basics. 

What to report? What not? What to deduct? If you understand these things, it will help you ask smart questions and make sure you're taking advantage of legitimate breaks. 

So whether or not you do your own taxes, I encourage everyone to brush up on a few fundamental tax concepts. It's worth the time and effort because, ultimately, it's not how much you earn but what you keep that counts.

What's included in gross income?

Your gross income, also called total income, includes two things: your earned income (wages, salary, tips, commissions and bonuses) and your unearned income (dividends, interest, capital gains). That may seem to cover just about everything. But, fortunately, there are some types of income the government doesn't touch. 

These are called exclusions—things like a gift or inheritance, child support, life insurance proceeds following the death of the insured, municipal bond interest, disability income if you paid the premium with after-tax dollars, and certain employee fringe benefits. You don't need to include this type of income in your total. 

That's the first bit of good news. The second is that once you've added up your total income, you can start subtracting.

How do you determine adjusted gross income (AGI)?

The next step is computing your AGI (adjusted gross income). Your AGI is what you get once you've done some subtracting. For instance, right off the bat, you can subtract certain things from your total income: a deductible contribution to an IRA or 401(k), alimony payments, qualified moving expenses and certain education expenses. If you're self-employed, you can subtract contributions to a small business retirement plan as well as health insurance premiums and half of the self-employment tax. The result is your AGI.

Your AGI is important because it determines your eligibility for certain other deductions and credits, as well as for a Roth IRA. 

How do you choose between standard and itemized deductions?

Once you know your AGI, the next step is to subtract either the standard deduction or your itemized deductions from your AGI—whichever is greater. If your financial situation is straightforward, the standard deduction might be the best and simplest choice. The 2016 standard deduction is $6,300 for single filers, $12,600 for married filing jointly. 

If you own property, run a business from home, have paid extensive medical bills or manage a lot of investments, you might be better off itemizing deductions. Itemized deductions include property taxes, state and local income taxes, specified medical and dental expenses that exceed 7.5% of your AGI, mortgage interest, margin interest paid, charitable contributions, casualty and theft losses and more. You can get a full list of legitimate itemized deductions at irs.gov. Also note that even if you don’t itemize deductions, you may be able to deduct up to $2,500 of student loan interest.

What's a personal exemption?

You can also subtract personal exemptions from your AGI. Personal exemptions are determined by the government and indexed annually for inflation. The personal exemption for your 2016 tax return is $4,050. You can claim one exemption for yourself, one for your spouse if you’re married and filing a joint return, and one for each qualified dependent, which can be a child or other relative.

What's the difference between marginal and average tax rates?

Once you've done all the subtracting, you're left with your taxable income—the amount you actually pay taxes on. This also determines your tax bracket. Here's where more confusion comes in because, in reality, you don't pay a flat rate on your taxable income. Rather, taxes are graduated. Here's an example.

Let's say you're single and your taxable income is $45,000, putting you in the 25% tax bracket. That 25% is your marginal tax rate, which is the percentage you pay on the last dollar of your taxable income. In actuality, according to the 2016 tax tables, you'd pay 10% on the first $9,275 of taxable income, 15% between $9,275 and $37,650—and 25% on the amount above that. That would give you an average tax rate of just over 15%. That sounds a lot better! (Between the two, your marginal bracket is the more important from a practical standpoint because that’s what determines how much of the next dollar of income you get to keep.) 

Who qualifies for a tax credit?

When it comes to reducing taxes, there's one more thing to be aware of: tax credits. A tax credit reduces the taxes you owe dollar for dollar. A $100 credit means you pay $100 less in taxes. There are a number of tax credits available depending on your income and personal situation, including credits for qualified adoption expenses, child and dependent care credit, residential energy credit and the Earned Income Tax Credit, which is available to low- to moderate-income workers.

Why it matters

You don't have to be a CPA or get bogged down in details, but these basics can go a long way in helping you use tax software or talk to a tax professional more knowledgably. Plus, while none of us enjoys paying taxes, feeling confident that you're not paying more than you owe may make it a little easier.

Next Steps

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Important Disclosures

Schwab does not provide tax advice. Clients should consult a professional tax advisor for their tax advice needs.