Getting tax terms straight can be a dizzying exercise. Remembering the difference between your income, investment income, gross income, and your adjusted gross income is important, but it’s tricky when you only need to think about it once a year. Locating and calculating your adjusted gross income using your W2 is especially important, as that is where you factor in your deductions.
Deductions are, hopefully obviously, pretty good. Getting them right could mean paying less in income taxes than you would otherwise. The stage where you calculate your adjusted gross income from your W2 is key for making sure you have all the deductions available to you. But how do you calculate your adjusted gross income in the first place, and what are some pitfalls to look out for?
First, start with your gross income.
The term “gross income” for tax purposes refers to how much you make annually before taxes. For instance, if you are salaried and your contract says you are supposed to make $45,000 a year, you would think that would be $3,750 a month. However, you have probably noticed your paychecks are a lot lower than that. That is due to your employer withholding taxes every time they pay you. This is one benefit of traditional employment and one less thing for you to worry about.
If you have freelance or investment income, you’ll need to factor that in as well. If you have a side gig or a small business, we know you think a lot about taxes. Remember that your gross income is what you make in total before you send in your quarterly taxes.
Deductions help the world go round or at least help take the sting out of tax season. How many children you have, charitable donations, your contribution to your 401k, your medical bills, or the interest on your student loan debt can all be possible deductions. You can check out a more complete list of deductions here, but the basic idea is that tax law acknowledges the stressors our life situations may put on our finances. It’s not perfect as it’s not always fair about what it chooses to incentivize. But if you have access to a break, you may as well take it.
We’ve talked before about how freelancers and small business owners are at a little bit of an advantage here. Think about everything you pay to advance your work or small business. It’s important not to get obscene with your deductions, but your situation means you have a lot more options than your friend who works in an office.
A quick note: while charitable donations are tax deductions, donations to political parties are not. Most contributions to socially-minded organizations should still be tax-deductible, but it’s something to check before deciding where and how much to contribute.
Adjusted Gross Income
Finally! Lets talk about adjusted gross income.
Your adjusted gross income is your gross income on your W2 minus your major deductions for the year. This decreases your taxable income, which can have an impact on your tax bracket.
For instance, say your gross income is $45,000, but you have $2000 worth of deductions for the year. This means your adjusted gross income is $43,000. The truth is that so long as you have everything in order and can back up all of your deductions, calculating your adjusted gross income is pretty straightforward.
Staying Organized is Essential
Honestly, the hardest part of calculating your adjusted gross income is just understanding all the terminology involved. That, and keeping your receipts in order.
The terminology is dense because taxes are very specialized. The language needs to be precise. But that still sometimes makes it harder for laypeople to get all the benefits they possibly can. Taking the time to do a quick Google search when you get your W2 just to make sure you understand all the terms and descriptions.
You need to be able to back up every deduction you claim. Make sure you keep detailed records, just in case something is brought into question. Likewise, making claims you are not entitled to is illegal. However, it’s always possible you have deductions you weren’t aware of. It’s just a little bit of extra work that can help April run more smoothly and leave you figuring out what you’re going to do with that tax return.