Before we begin the process of understanding taxes, take a look at the formula below to calculate our taxes:
To Calculate Taxes Payable:
Result is known as Adjusted Gross Income (AGI)
(Subtract Standard Deduction or Itemized Deductions)
(Subtract Number of Exemptions × $3,100)
Result is your Total Taxable Income
(Subtract Tax Credits)
Result is the actual tax to be paid
Taxable income is the amount of your income on which you pay taxes. Yeah, we know. You thought for sure you were paying taxes on every cent you make, or your taxes wouldn't consume such a large chunk of your income, right? Well, if it seems that way, you're right. We work for a good part of the year just to make the money that we pay in taxes, and it can be mighty discouraging if you dwell on it.
But you're not going to dwell on it. Instead, you're going to figure out how to make less of your income taxable. You're still going to pay taxes; don't get us wrong. But you might be able to whittle them down a little bit and give yourself a little more money for other things.
Show Me the Money
Your taxable income is the amount of your income on which you begin calculating your final tax liability. Nontaxable income is income that is exclud-ed from tax liability.
You have to pay taxes on the money you earn by working, your income may come from sources other than your paycheck. For instance, the interest you earn on the money in your 401(k) plan is income, but it's not taxable income. This income is referred to as nontaxable income. You get to earn it for free (for now, anyway). Theoretically, you could make all your income nontaxable. Of course if you did that, then you wouldn't have a salary or any money to live on. But at least you wouldn't be paying any taxes!
Let's have a look at what's taxable income and what's not. Taxable income includes the following:
- Your salary, with the exception of money you may have deducted and put into a 401(k) plan
- Interest earned on savings and checking accounts
- Interest on all bonds except municipal (tax-free) bonds and dividends on investments
- Bonuses, severance pay, and sick pay from your employer
- Unemployment compensation
- Capital gains on mutual funds and other investments. (Capital gains are the amount by which proceeds from the sale of a capital asset exceed the cost. They're the profit you make.) Although the tax rate on capital gains is different than regular taxable income, it's still considered taxable income.
- Bartering, royalties, and gambling winnings, including lottery winnings
- Most withdrawals from an IRA or annuity
Nontaxable income includes the following:
- Money you contribute to certain types of retirement accounts
- Disability income on benefits you paid for with after-tax dollars
- Funds contributed to a Flexible Spending Account used for childcare or medical expenses through work
- Return of invested capital—that is, your money invested that is returned to you
- 401(k) money that's rolled over into another 401(k) or IRA when you change jobs
- Child support payments
- Money you've lent that is repaid
Use this information about taxable and nontaxable income to help you to be smart when it comes time to figure out what to do with the money from your salary that you don't need to cover your expenses.