The greatest challenge in determining your total tax liability stems from an incomplete understanding of what income figure is supposed to be used during each stage of the process in combination with a poor grasp on when deductions, exemptions and credits are applied to those calculations. Regardless of your level of total taxable income or applicable tax bracket, calculating your annual tax liability starts with determining your gross income.

Gross Income Calculation

Gross income is also expressed as taxable income, which includes money you have earned from wages, tips, bonuses, commission, alimony, business income (full or part-time), dividends, interest, capital gains from the sale of stocks, unemployment, or Social Security. Income that is considered nontaxable and therefore not included in the gross income calculation includes child support, federal tax refund payments, gifts, inheritances, tax-exempt interest from bonds and workers compensation benefits. Once gross income is totaled by adding together taxable earnings, you can apply certain deductions to the amount that results in the adjusted gross income.


The IRS allows you to reduce your taxable income by applying above-the-line deductions to your gross income. These deductions include (but are not limited to) IRA contributions, education expenses such as tuition and book costs, alimony payments, paid student loan interest and moving expenses if your relocation for employment was over 50 miles away. Small business owners may also deduct health insurance premiums as well as half of total Federal Insurance Contributions Act (FICA) taxes paid. Once these deductions are subtracted from gross income, you are left with your adjusted gross income figure.


Unlike above-the-line deductions, exemptions are taken from your adjusted gross income, not your total gross income. Exemptions are set dollar amount deductions that can be taken for yourself, your spouse, or your dependent child or relative. These exemptions can be helpful in reducing your tax liability by directly decreasing your adjusted gross income. If you are an employee who receives a W2, your personal and dependent exemptions are the most common reductions applied to your adjusted gross income amount.

Tax Credits

While deductions and exemptions are an integral part of lowering your taxable income, tax credits are directly applied to the total tax you owe, making them a dollar-for-dollar reduction in your tax liability. Your eligibility to take certain tax credits is based on your adjusted gross income and your modified adjusted gross income, not your gross income. Your adjusted gross income determines whether you can apply the Earned Income Credit and the Child/Dependent Care Credit, while your modified adjusted gross income determines whether you can use certain credits, such as the Adoption Credit. Once you have applied available tax credits to your adjusted or modified adjusted gross income figures, your total tax owed is determined and you can calculate your net income.

Although determining your gross income is the first step in calculating your total tax liability each year, only your deductions are based on that total. Adjusted gross income is the figure used to determine what credits and exemptions are available to you to reduce the total tax you owe. Understanding the difference between these income figures can ease the process of filing tax returns and reduce the potential for costly mistakes.

  1. What is the difference in tax liability between gross income and other kinds of income?

    Find out how the U.S. government taxes worker's earnings, whether it is gross income or income exempted or excluded from ... Read Answer >>
  2. What is the difference between AGI (adjusted gross income) and gross income?

    Find out the differences between your annual gross income and your adjusted gross income, or AGI, both of which are calculated ... Read Answer >>
Related Articles
  1. Taxes

    What is Gross Income?

    Gross income is an individual’s total income before taxes and other adjustments are considered.
  2. Taxes

    How To Calculate AGI For Tax Purposes

    The first step in completing your taxes is calculating your adjusted gross income. Here’s how.
  3. Taxes

    Explaining Taxable Income

    Taxable income is the net of gross income and allowable deductions.
  4. Taxes

    7 Tax Terms Explained

    As the tax season begins, there are certain words you need to know. Read on to see what they are.
  5. Retirement

    Top Tax Tips for Retirees

    Filing your taxes during retirement can be just as time consuming as when you were employed. We have some tips to help you out.
  6. Personal Finance

    The Ultimate Tax-Time Checklist

    Find out what information you need to pull together before filling out your return.
  7. Taxes

    How To Calculate AGI For Tax Purposes

    Determining your adjustable gross income is essential in the tax filing process. Here are some tips for doing so.
  8. Taxes

    Top Tax Advantages of Buying a Home

    Don't forget these deductions and credits that homeowners can use to reduce their tax bill.
  9. Taxes

    Are You Missing Out On These Tax Exemptions?

    To lower your tax bill, make sure that you're taking all the exemptions that apply to you.
  10. Taxes

    5 Groups That Don't Pay Taxes

    Now that you've paid your share, find out who didn't have to pay taxes this year.
  1. Adjusted Gross Income - AGI

    A measure of income calculated from your gross income and used ...
  2. Gross Earnings

    1. For individuals, the total income earned in a year, as calculated ...
  3. Taxable Income

    Taxable income is described as gross income or adjusted gross ...
  4. Modified Adjusted Gross Income - MAGI

    The amount of income that determines how much of an individual's ...
  5. Future Income Tax

    Income tax that is deferred because of discrepancies between ...
  6. Deductible

    1. The amount you have to pay out-of-pocket for expenses before ...
Hot Definitions
  1. Nostro Account

    A bank account held in a foreign country by a domestic bank, denominated in the currency of that country. Nostro accounts ...
  2. Retirement Planning

    Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve ...
  3. Drawdown

    The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
  4. Inverse Transaction

    A transaction that can cancel out a forward contract that has the same value date.
  5. Redemption

    The return of an investor's principal in a fixed income security, such as a preferred stock or bond; or the sale of units ...
  6. Solvency

    The ability of a company to meet its long-term financial obligations. Solvency is essential to staying in business, but a ...
Trading Center