There are numerous tax terms that are beneficial to know and understand when you are preparing and filing your tax returns. Some of the most important terms include gross income, adjusted gross income, modified adjusted gross income and taxable income, and each has a distinctive purpose in tax accounting. Ease the pain of determining your tax liability by developing a concrete understanding of each term, especially gross income and taxable income.
According to the U.S. Internal Revenue Service (IRS), your gross income is the total of all of your earnings and income sources throughout the course of any given year. If you are not self-employed, your gross income includes wages and salary from a W-2 position as well as the commissions or bonuses paid out from an employer. If you are a business owner or you are self-employed, your gross income includes total earnings from the business minus any business-related expenses, also known as net business income. For the purpose of tax accounting, your gross income also includes any investment earnings, which could include gains from stock sales or dividends paid out over the year, rental property income, taxable withdrawals from retirement accounts, and Social Security income or disability benefits.
Once you have determined your gross income from all sources, you can then calculate your taxable income. Your taxable income differs from your gross income in that it counts allowable deductions, exemptions and other subtractions for which you may be eligible. This figure can be drastically smaller than your gross income depending on the number of deductions that you take or exemptions that you can apply. Although items such as child support may be included in your gross income calculation, this is not considered to be a part of your taxable income.
Getting to Taxable Income from Gross Income
For most individuals, the purpose of tax accounting is to reduce gross income down to the lowest possible amount of true taxable income for each year. The most common way to complete this task is to itemize your deductions on a tax return, especially if you are self-employed. You may also take a standard deduction determined by the IRS each year to reduce your gross income down to the total taxable amount when there are not enough deductions available for you to itemize. Despite what your gross income may be, you should be the most concerned with the taxable income calculation on your annual tax return.
Understanding the difference between certain tax terms including gross income and taxable income allows for a much smoother tax accounting process each year, and may also ensure that individuals and business owners are only paying what is owed based on taxable income alone.