When you earn an income, you typically owe taxes to federal, state, and local governments. Understanding which income is taxable and how to minimize your tax burden is essential. Familiarizing yourself with taxable income, deductions, and tax credits is crucial, as these are distinct and sometimes intricate components of the U.S. tax system.
Understanding Taxable Income
Taxable income accounts for much of the tax paid to the government each year.
Definition
Taxable income, by definition, is the portion of your gross income used to determine how much tax you owe each year. It is this portion that you pay taxes on.
Components
Taxable income includes earned and unearned income. Unearned income includes government benefits like unemployment or disability, lottery winnings, canceled debts, and strike benefits. Taxable income for earned income relates to earnings from employment or services provided.
Tax Brackets and Progressive Taxation
In the U.S., the tax system is progressive, which means individuals with higher incomes pay a higher percentage in taxes. Tax brackets range from 10% to 37%. As a result, lower-income people pay a smaller percentage of their earnings in taxes than those in higher tax brackets.
Below are the tax brackets in 2024, but these can change over time.
| Tax Rate | Single Filers | Married Filing Jointly | Head of Household |
|---|---|---|---|
| 10% | $0 to $11,600 | $0 to $23,200 | $0 to $16,550 |
| 12% | $11,600 to $47,150 | $23,200 to $94,300 | $16,550 to $63,100 |
| 22% | $47,150 to $100,525 | $94,300 to $201,550 | $63,100 to $100,500 |
| 24% | $100,525 to $191,950 | $201,550 to $383,900 | $100,500 to $191,950 |
| 32% | $191,950 to $243,725 | $383,900 to $487,450 | $191,950 to $243,700 |
| 35% | $243,725 to $609,350 | $487,450 to $731,200 | $243,700 to $609,350 |
| 37% | $609,350 or more | $731,200 or more | $609,350 or more |
Understanding your financial obligation can be complex. Therefore, you should work closely with your tax professional to ensure you report your income correctly.
Understanding Deductions
There are two ways to reduce the amount of taxes you pay. That includes tax deductions and tax credits.
Tax deductions reduce your taxable income. They lower the income amount you're taxed on based on your highest federal income tax bracket. These deductions arise from expenses the government recognizes as eligible to decrease tax liability. Here are some types of deductions to consider:
Standard Deductions
Standard deductions are a specific dollar amount that reduces your taxable income. It is the sum of the basic standard deduction for a specific group. This amount is adjusted each year. For example, if you are single or married filing separately, the standard tax deduction for 2022 was $12,950. If you were married, filing jointly, and surviving spouses, the standard deduction for tax year 2022 was $25,900. For those filing head of household, the standard deduction was $19,400.
Itemized Deductions
Some people may not wish to take the standard deduction because they have more deductions over and above the standard deduction. For example, suppose you have excessive state or local income taxes, medical and dental expenses, and high mortgage interest. In that case, you may apply itemized deductions that, when added together, will typically be more than the standard deduction.
Above-the-Line Deductions
"Above-the-line" deductions are subtracted from your gross income to determine your adjusted gross income (AGI). Examples include retirement contributions, student loan interest, certain business expenses, and specific healthcare costs. These deductions are advantageous because they reduce your AGI, which can affect your eligibility for other tax benefits or deductions based on your AGI.
Understanding Tax Credits
Tax credits are a specific dollar amount that reduces the taxes you owe. These are typically dollar-for-dollar reductions on your taxes. They reduce the amount of income tax you pay.
Deductions vs Credits
Tax credits are a way to reduce the amount of taxes you owe, providing a specific dollar-for-dollar reduction in your taxes owed. Tax deductions, by contrast, reduce how much of your income is subject to taxes.
Common Tax Credits
Tax credits apply to many things. Some examples include:
- Earned income tax credit
- Charitable organization tax credits
- American Opportunity Tax credit
- Lifetime learning credit
- Adoption credit
- Saver’s credit
Strategies for Maximizing Deductions and Credits
As you approach the tax year, it's vital to recognize your potential tax obligations. Then, strive to make the most of any deductions and credits available. Your best approach is to stay informed. Understand the available tax deductions and credits and determine which ones apply to you. For instance, if you're purchasing a house, look into the benefits of home mortgage points. Also, collaborate with your tax expert to optimize your charitable donations.
Takeaways
Taxes can be complicated, and an accountant who knows your specific situation is the best person to guide you. However, evaluate the tax consequences before making a significant investment or altering your financial status. By doing so, you'll find numerous strategies to lessen your yearly payment to the IRS. Taking advantage of tax deductions and credits can significantly benefit your financial management.