Taxable Income
To determine your tax refund or how much tax you owe, it’s important to first determine your taxable income. This can be done using your W-2 form. Deductions and exemptions, such as 401(k) contributions or pension plans, are subtracted from gross income. The remaining amount is taxable income.
Other Taxable Income
Interest income, such as interest on savings accounts, fixed deposits, or tax refunds, is taxed as ordinary income, although some municipal bonds may be exempt. Gains from assets sold for less than a year are short-term capital gains and taxed as ordinary income. Gains from holding assets for more than a year are long-term capital gains, which are subject to different rules. Ordinary dividends are taxed as ordinary income, while qualified dividends are taxed at a lower rate. Income from rent or a business in which you are not actively involved is considered passive income.
Exemptions
A tax exemption refers to an amount that is not taxed, thereby reducing taxable income. For example, many religious institutions and charities are tax-exempt. In some places, duty-free shopping is also an example of a tax exemption.
Tax Deductions
Deductions are linked to expenses and reduce taxable income. There are two types—Above-the-Line (ATL) and Below-the-Line (BTL). ATL deductions reduce AGI directly, while BTL deductions are applied later.
MAGI (Modified Adjusted Gross Income)
MAGI is used to determine whether you are eligible for certain deductions. It is calculated by adding back certain items to AGI, such as student loan interest, IRA contributions, rental losses, etc.
Above-the-Line Deductions
These reduce AGI. Examples: traditional IRA contributions, student loan interest, qualified education expenses, job change expenses, tips and some overtime income, car loan interest, and additional deductions for seniors.
Below-the-Line Deductions
These include standard deductions or itemized deductions. Such as home loan interest, charitable donations, medical expenses, and state/local taxes. These directly reduce taxable income.
Business Expenses
If an expense is necessary and ordinary to run a business, it can be deducted. However, it must be genuinely related to the business and incurred for the purpose of making a profit.
Standard vs. Itemized Deduction
Standard deductions are fixed amounts, while itemized deductions add together different expenses to arrive at a total deduction. Most people choose the standard deduction because it is easier. In 2025, it is $15,000 (single) and $30,000 (married jointly).
Tax Credits
Tax credits directly reduce your tax bill. For example, a $1,000 credit reduces your tax liability by the same amount. Refundable credits can also result in a refund, while non-refundable credits only reduce your tax to zero.
Common Tax Credits
These include the Earned Income Credit for low-income individuals, the Foreign Tax Credit for foreign income, the Child Tax Credit for children, the Child Care Credit for childcare expenses, the American Opportunity and Lifetime Learning Credit for education, and the Saver’s Credit for retirement savings.
Energy Credits
Tax credits can also be obtained for installing solar, wind, or energy-efficient equipment in your home.
Alternative Minimum Tax (AMT)
The AMT is a separate tax system that doesn’t allow for many deductions. If your income exceeds a certain threshold, you must pay the higher of the ordinary tax or the AMT. To reduce this, increasing retirement contributions and reducing certain deductions can help.
It is therefore important to understand income, deductions, credits, and rules to accurately calculate taxes.