How the IRS Calculates Your Income Tax

Calculator and silver pen used to calculate the taxes and numbers on the documents.

The U.S. tax system and codes are rather complex to understand. When calculating the amount of federal income tax you owe, the IRS goes through several steps, such as excluding certain items from your income, applying the current tax brackets, and making adjustments for any tax credits you may qualify for. With the broad concept of the process in mind, let’s take a brief look at how exactly the IRS calculates your income tax so you can gain an idea as to where your future tax bills are coming from. 

Step One: Starting with Your Gross Income 

First and foremost, the IRS initiates the process with your gross income, which includes all of the money that you make. In addition to the income you earn from your job, gross income also includes business income, retirement income, interest income, dividend income, and capital gains from selling investments—just to name some of the most common sources. As an example let’s say that you earned the following income:

  • Salary of $50,000
  • Net business profit of $20,000 from doing consulting work
  • Interest income of $5,000

In this case, your gross income for the year would be $75,000. Although, you don’t pay taxes solely based on your gross income. This is simply just the starting point. 

Step Two: Determining Your Adjusted Gross Income

Secondly, certain adjustments are applied to your gross income to determine the adjusted gross income. This is also known as an “above the line” deductions because you are allowed to use them regardless of whether you itemize deductions or go with the standard deduction. Adjustment to your income include:

  • Deductible retirement contributions
  • Student loan interest
  • K-12 educator expenses
  • Moving expenses
  • Alimony paid
  • Bad debts
  • Tuition and fees

Step Three: Applying Deductions to Find Taxable Income

Filers have two choices. They can either add up all of the tax deductions to which they’re entitled or they can choose to take the standard deduction. You can choose to take your corresponding standard deduction or take all of your actual tax deductions, whichever is higher. Mortgage interest, charitable contributions, state and local taxes, and certain medical expenses are some of the most common deductions, but there are many others. The majority of filers make use of the standard deduction, but it’s often a good idea to calculate your taxes using both methods to see which is most in your favor. 

Step Four: The Tax Brackets

Next, your taxable income is applied to the marginal tax brackets. They’re called marginal tax brackets because not all of your taxable income is taxed at the same rate. What this is means is that the 10% tax rate will always be applied to the first $9,325 of income, regardless of how much a taxpayer made. It’s also important to realize that the tax brackets from former tax brackets are very different than the tax brackets that will be applied to this year’s returns, so it’s vital to be sure you’re looking at the correct tax year. As far as qualified dividend and long-term capital gain taxes go, they are taxed at different and more favorable rates of 0%, 15%, or 20%, depending on the taxpayer’s marginal tax brackets. High-income taxpayers may also have to pay an additional 3.8% net investment income tax on any dividends or capital gains as well. 

Step Five: Applying for Any Qualifying Tax Credits 

The last and final step is to apply any tax credits to which you are entitled. Unlike deductions, which reduce the amount of your income subject to tax, tax credits reduce the amount of tax you owe dollar-for-dollar. 

Some of the most common credits filers apply for consist of the following:

  • The American Opportunity Credit and Lifetime Learning Credit for qualified tuition and fees
  • The Child Tax Credit
  • The Earned Income Tax Credit, or EITC
  • The Child and Dependent Care credit 
  • The Retirement Savings Contribution Credit, or Savers Credit

Determining How Much You’ll Actually Owe the IRS

To determine how much you’ll actually owe the IRS, take the tax you calculated in step five and subtract the amount that was withheld from your paychecks for federal income tax for the year. You can find this information on your last pay stub for the year, listed under the year-to-date column. If this produces a positive number, this is how much you can expect to owe the IRS. If the result is negative, this is how much of a tax refund you can expect to get back. 

Clifford, Ross, Raudenbush & Cooper, LLC: The Tax Professionals You Need 

Our tax preparers have over forty years of experience, so we have all the knowledge you need in regards to the IRS and your income tax returns. Contact us today to prepare for the upcoming tax season and to learn more about our tax preparation services.