Federal Taxes Explained With a Basic Formula
Filing taxes for the first time can feel overwhelming, especially when every form seems to speak its own language. But here’s the good news: a basic individual tax calculation follows a straightforward process.
Federal Tax Calculation: A Simple Breakdown
Think of the tax process as a step-by-step formula that calculates all the money you earned and shows you what you owe (or will get back from the IRS).
Income From All Sources
Start with all your income: wages, salaries, tips, bonuses, freelance or self-employment earnings, rental income, interest, dividends, and other taxable forms of compensation. This total forms the base for your tax calculation.
Minus: Adjustments to Income
These are specific deductions you can claim before calculating your adjusted gross income. Examples include educator expenses, contributions to a Health Savings Account (HSA), student loan interest, penalties for early withdrawal from savings, and certain self-employment deductions, and more.
Equals: Adjusted Gross Income (AGI). Your AGI is one of the most important numbers on your tax return; it determines your eligibility for many credits and deductions.
Minus: Standard Deduction or Itemized Deductions
Consult a tax advisor for advice on which makes the most sense or is required for your specific tax situation.
Equals: Taxable Income. This is the portion of your income that is actually subject to federal income tax.
Minus: Tax Before Credits
After applying the tax brackets to your taxable income, you determine your initial tax liability, which is the amount of tax you owe before credits.
Minus: Credits
Tax credits directly lower the amount of tax you owe. They usually fall into three categories:
Nonrefundable – Can reduce tax to zero, but does not create a refund.
Refundable – Can reduce taxes below zero, leading to a refund.
Partially Refundable – A portion of the credit can be refunded even after wiping out your tax owed.
Equals: Total Tax. This is your final tax liability after credits are applied.
Minus: Payments and Refundable Credits
This includes federal income tax withheld from your paycheck, estimated payments, and any refundable credits you qualify for.
Equals: Refund or Amount Due. If your payments exceed your total tax, you'll receive a refund. If they are less, you owe the difference. Quick Example
This is a very basic example and does not include employer retirement contributions, pretax benefits, or credits.
Total Income: $75,000
Minus Adjustments: $3,000
Equals AGI: $72,000
Minus Deduction: $15,750
Equals: Taxable Income: $56,250
Tax Before Credits: $6,273
Total Credits: $0
Equals: Tax After Credits: $6,273
Minus: Federal Tax Withheld: $8,112
Equals: Amount Refunded: $1,839
Key Takeaways
This example shows how withholding throughout the year affects your final refund. Remember, items like retirement contributions and income adjustments can reduce taxable income, while qualified tax credits can reduce taxes owed before withholdings are factored in.
Disclaimer: Creek & Lyells Financial Literacy Foundation does not provide financial services, nor does it recommend or advise visitors to open accounts or buy or sell securities. All content on this blog is for educational purposes only. While we strive to provide accurate, relevant, and well-vetted information, visitors should consult a licensed financial professional and carefully evaluate the risks of any financial decision before taking action.