Income Tax Fundamentals

What is "gross income"?

Your gross income is the total income reported on your tax return, and includes items such as wages, taxable interest, dividends, and capital gains. Basically, unless a type of income is specifically excluded by the Internal Revenue Code, it is included in determining gross income.

Internal Revenue Code (IRC) Section 61(a) defines gross income as: [...] all income from whatever source derived, including (but not limited to) the following items:

1. Compensation for services, including fees, commissions, fringe benefits, and similar items
2. Gross income derived from business
3. Gains derived from dealings in property
4. Interest
5. Rents
6. Royalties
7. Dividends
8. Alimony and separate maintenance payments
9. Annuities
10. Income from life insurance endowment contracts
11. Pensions
12. Income from discharge of indebtedness
13. Distributive share of partnership gross income
14. Income in respect of a decedent
15. Income from an interest in an estate or trust

What's not included in gross income? Items that are specifically excluded from gross income include gifts and inheritances, life insurance death benefits, scholarships, payments for injury or sickness, certain employment fringe benefits, certain military pay and benefits, interest on some state and local bonds, and limited gain on the sale of a principal residence. In some cases, income is specifically excluded if certain conditions are met. For example, Social Security benefits may be excluded from income, but a portion of benefits is included once your income reaches a certain level. Earnings within certain tax-advantaged savings vehicles like IRAs, 401(k) plans, and 529 plans are excluded from current income, provided certain criteria are met.

What is "taxable income"?

You start with your gross income, then subtract your adjustments to income — sometimes called "above-the-line" deductions — to determine your adjusted gross income (AGI). Adjustments to income may include deductions for student loan interest, moving expenses, and contributions to health savings accounts and traditional IRAs.

You're generally also able to take a standard deduction amount that's based on your filing status. If you choose, you can itemize deductions on IRS Form 1040, Schedule A, rather than claiming the standard deduction. Itemized deductions include deductions for medical expenses, mortgage interest, state and local taxes, and charitable contributions.

You're also able to claim specific dollar exemptions for yourself, your spouse (if you are married and file a joint return), and your dependents. Subtracting adjustments to income, deductions, and exemptions from your gross income results in your taxable income, which is used to calculate your federal income tax.

Choosing an income tax filing status

Your filing status is especially important because it determines, in part, the tax rate applied to your taxable income, the amount of your standard deduction, and the types of deductions and credits available. Because you may have more than one option, make sure you understand the qualifications. Your filing status is determined as of the last day of the tax year (December 31). There are five possible filing statuses:

Single

To use the single status, you must be unmarried or separated from your spouse by either divorce or a written separate maintenance decree on the last day of the year.

Married filing jointly

Generally, you must be married and living with your spouse; you can be married and living apart provided that you are not legally separated under a divorce decree or separate maintenance agreement. When filing jointly, you and your spouse combine your income, exemptions, deductions, and credits.

Married filing separately

You must be married on the last day of the year. Using this filing status, you would report only your own income and claim only your own deductions and credits.

Head of household

You must be a U.S. citizen or resident alien for the entire year and: (1) be unmarried at the end of the year (an exception applies if you live apart from a spouse and meet certain criteria); (2) maintain a household for your child, dependent parent, or other qualifying dependent relative (the household must be your home and generally the main home of the qualifying individual for more than half of the year); and (3) provide more than half the cost of maintaining the household.

Qualifying widow(er) with dependent child

To claim this filing status, all of the following must be true: (1) your spouse died in either the last tax year or the tax year before that; (2) you qualified to file a joint return with your spouse for the year he or she died; (3) you have not remarried before the end of the tax year; (4) you have a qualifying dependent child; and (5) you provide over half the cost of keeping up a home for yourself and your qualifying child.

Determining your tax

The federal income tax system is progressive, with higher tax rates applying as the level of taxable income increases. There are seven tax rate brackets ranging from 10% to 39.6%. A tax rate bracket is the tax rate that applies to a specified range of taxable income. For example, if you file as single for 2017, the first $9,325 of your taxable income is taxed at a rate of 10%, but the next dollar in taxable income is taxed at a rate of 15%. You'll generally calculate your tax by looking up your taxable income in a tax table, or by using a tax rate schedule specific to your filing status.

There are, however, a number of complicating factors in determining the correct amount of tax. For example, special rules and rates apply to long-term capital gains and qualified dividends. You might also be affected by the alternative minimum tax (AMT), rules that apply to a child's unearned income (i.e., the "kiddie tax" rules), or the 3.8% net investment income tax that applies on the unearned investment income of some high-income individuals.

Fundamentals at a glance