If you live in the United States, it’s that time of year again! Have you filed your taxes yet? April 18 is the filing deadline for individual income tax returns (Procrastinators, rejoice! You have three extra days to file this year).
While the various tax forms, rules, and regulations can be confusing, the basic tax formula is actually pretty simple. If you break it down, your tax refund or the tax you have to pay is calculated like this:
Seems easy enough, right? But what do each of those terms actually mean?
Total Income vs. Adjusted Gross Income (AGI) vs. Taxable Income
There are many “income” amounts that appear on your tax forms.
Total Income simply represents all the money that you made in compensation during the year—whether that was from your employer, through investment interest, or other forms of compensation.
Adjusted Gross Income (AGI) is the amount of money that you made this year, less any specific deductions.
Taxable Income is the amount that you will use to calculate your tax.
Deductions vs. Credits
Deductions and credits are very similar, in that they both reduce your tax, but how and when they reduce your tax differs.
Deductions are amounts that you subtract from your income, and are taken out before you calculate the total tax owed.
Credits are amounts that are taken out after you have already calculated your tax, so they reduce your tax directly. Credits are generally more beneficial than deductions because they reduce your tax directly dollar-for-dollar, whereas deductions reduce your taxes indirectly by reducing your income.
To illustrate this, let’s take a simple example. Say that you made $100 this year, and your tax rate is 10%. Let’s say that you have an option to take a $15 deduction or a $15 credit. These two options can be illustrated with the formulas below:
Deduction Option |
Credit Option |
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| Total Income | $100 | $100 | ||
| – Deductions | - | $15 | - | $0 |
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| AGI | $85 | $100 | ||
| Tax (AGI x 10%) | $8.50 | $10 | ||
| – Credits | - | $0 | - | $15 |
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| Total Tax | $8.50 | $5 refund | ||
In this example, if you take the credit you actually don’t owe any tax, but if you take the deduction you would owe $8.50 of tax. This simple illustration shows that credits are (almost always) more beneficial than deductions.
Why do credits and deductions exist? Well, it isn’t because the government wants to reduce your tax liability out of the goodness of their heart. They exist because the government is trying to incentivize certain behavior. For example, they want people to pursue higher education, so there are tuition deductions and credits and student loan interest is deductible.
Standard vs. Itemized Deduction
While all other deductions apply to people differently, every tax payer is entitled to either the Standard or Itemized Deduction.
The Standard Deduction is a set amount that every tax payer can subtract from their income. The amount varies depending on your filing status, but it is adjusted each year to account for inflation.
Taxpayers also have the option to itemize their deductions. Itemized Deductions are the total of specific amounts, including medical and dental expenses, amounts given to charity, amounts lost to theft, taxes and interest paid, and any job expenses that were not reimbursed by your employer.
If the total of all these amounts is greater than the standard deduction amount, you should itemize your deductions. If the total of these amounts is less than the standard deduction, you should take the standard deduction.
Part of the reason that the standard deduction exists is because, for most people, the things that are included on the itemized deduction list are often hard to track and value. For example, giving a box of clothing to your local charity is deductible, but the value of that clothing is often subjective and hard to determine. You also may give small amounts of money to charities here and there that would be hard to track over the year.
Under this system, taxpayers can still take a deduction, without having to worry about tracking every dollar. IRS data indicates that roughly 30% of Americans itemize their deductions, and high-income taxpayers are more likely to itemize.
Exemptions
Each taxpayer who is not claimed as a dependent can claim a personal exemption. Taxpayers can also claim an exemption for each person that they list as a dependent. The exemption is a standard amount that reduces your adjusted income.
To determine your exemption, simply count the number of dependents that you claim (including yourself and your spouse) and multiply it by the exemption amount. Exemptions reduce your income to account for the fact that you have to pay money to take care of yourself and attempt to align the tax amount with a household’s ability to pay tax.
There are hundreds of pages of rules and regulations in the Internal Revenue Code, and it changes constantly, but these simple terms will help you to better understand your return.
