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How to calculate taxable income and tax liability

Income tax calculation formula

  Formula Examples
Gross income Wages IRA distributions
Interest Pensions & annuities
Dividends Rental income
Tax refunds Unemployment compensation
Alimony received Social Security Benefits
Business income Farm income
Capital gain (loss) Child's investment income
Other gains Other income (i.e. punitive damages)
  - (minus)    
For AGI Adjustments Health savings account deduction Business expenses of reservists, fee-basis government officials (Form 2106)
Moving expense Alimony paid
1/2 of self-employment tax IRA deduction
Self-employed health insurance deduction Student loan interest deduction
Self-employed retirement plan Tuition and fees
Penalty on early withdrawal of savings Domestic production activities deduction (Form 8903)
  = (equal)    
  AGI (Adjusted Gross Income)    
  - (minus)    
From AGI Standard Deductions1
Itemized Deductions Medical Investment interest
State and local income or general sales taxes Charity contributions
Real estate taxes Casualty or theft losses
Personal property taxes Unreimbursed employee expenses, such as employee travel (meals & lodging), transportation, entertainment, home office expenses, union dues, professional dues & memberships, subscription to business journals & magazines, job seeking expense, small tools, supplies, work clothes & uniforms
Home mortgage interest Tax preparation fees and advices
Mortgage insurance premiums Other exp. (i.e. gambling losses)
  - (minus)    
  Personal exemptions $3,800 per qualifying individual (2012)
  = (equal)    
  Taxable income    


What include into gross income for tax purposes

You need to add any income that you have for the year from any source derived (tips included). Then you need to take away any adjustments to gross income which sometimes referred to as “above the line deductions”. Usually there are not many of them and therefore not many can use those deductions unless you were self-employed, student or paid alimony during the tax year. Do not be confused with alimony paid and child support which is not taxable and not tax deductible. That way you will arrive at your AGI (Adjusted Gross Income).

Standard deduction vs Itemized deductions

Next step is to determine what is more beneficial to take a standard deduction or itemize deductions. Taxpayers are allowed to choose the one that is higher. However, if you file married filing separately and your spouse decided to itemize you will be bound to itemize as well, even though it might be less advantageous for you than taking the standard deduction. Usually people want to itemize if they have large out of pocket medical bills, home mortgage expenses or large purchases, such as acquisition of a car during the tax year. Mostly people choose standard deductions because they are more advantages for them.

1Depending on your filing status you can take one of the following standard deductions (2012), such as for

- single - $5,950

- married filing jointly - $11,900

- married filing separately - $5,950

- head of household, or $8,700

- qualifying widower -$11,900

- person who can be claimed on someone else's return - $950 or earned income + $300, but up to $5,950

Plus you can be qualified for additional standard deductions, such as for age (65 or older) and blindness. Note that you cannot take the additional standard deductions if you itemize.


After that you need to calculate your personal exemptions. Taxpayers are allowed to take one personal exemption for oneself, one for a spouse, and one for each dependent. Therefore, you need to add all exemptions together and multiply it by the exemption amount for the tax year.

Taxable income

Once you subtract standard (itemized) deductions and exemptions from AGI you will arrive at your Taxable Income. Then depending on the amount you might use Tax Tables or Tax Computation Worksheet. You have to use the Tax Computation Worksheet from IRS Publication 17, if the taxable income is $100,000 or more to determine your tax liability. Lastly, you need to subtract prepayment (federal income tax withheld from Froms W-2 and 1099) and / or credits (additional tax credit, American opportunity credit, if applicable) from your tax liability to find out what your Refund or tax due is.


Form 1040 (2012)