TAX READ TIME: 2-3 MIN
Understanding Income Taxes
Income taxes can seem complex, but understanding the basic process can help you plan for retirement and other financial goals. Americans spend an estimated 7.1 billion hours each year complying with tax requirements, which represents approximately $388 billion in economic value. 1
While many taxpayers choose to hire a tax professional, understanding how income taxes work can provide clarity and support better financial decision-making. This article provides an educational overview of the income tax process. Remember, this material is not intended as tax or legal advice. Consult a qualified professional for guidance specific to your situation.
Getting Started: Gross Income
The tax process begins with income. Generally, most income is taxable. A taxpayer’s gross income includes wages, investment income, interest, pensions, and other sources.
Not all money received counts as taxable income. Some common exclusions include:
- Gifts and inheritances2
- Workers’ compensation benefits
- Welfare benefits
- Cash rebates from a dealer or manufacturer
Adjusted Gross Income (AGI)
From gross income, taxpayers can subtract specific adjustments to arrive at their adjusted gross income (AGI). Adjustments may include contributions to retirement plans, half of self-employment taxes, and other qualifying items.
Deductions: Standard vs. Itemized
After AGI is calculated, deductions reduce taxable income. Taxpayers can choose between the standard deduction or itemized deductions.
The standard deduction varies based on filing status, as shown by the IRS. Itemized deductions may include:
- State and local taxes (up to certain limits)
- Charitable contributions
- Mortgage interest on qualified home loans3
- Certain unreimbursed job expenses
Once deductions are applied, the result is taxable income, which determines your initial or gross tax liability.
Tax Credits
Tax credits further reduce your tax liability. Credits can be available for a variety of purposes, such as energy-saving home improvements. The final result after credits is known as net tax.
Key Points for Retirement Planning
Understanding income taxes is important for retirement planning. Adjusting contributions to retirement accounts, evaluating potential deductions, and considering tax credits can help manage future tax obligations.
Keep in mind that the tax code can change annually, and limits on deductions or credits may vary. Consult a qualified tax professional or financial advisor when planning retirement strategies to ensure compliance with federal and state regulations.
Summary
While filing taxes can be time-consuming, knowing the steps—from gross income to net tax—can improve your understanding of how income taxes affect retirement planning. Begin with income, subtract adjustments, apply deductions, and factor in tax credits to estimate your tax position.
