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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.

Deductions

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.

Exemptions

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.

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