How Federal Taxes Work

By: Dave Roos

Taxable Personal Income

The simple purpose of the 1040 federal income tax form -- despite its baffling appearance -- is to calculate how much money you earned and how much of that money should be taxed. To do this, you start with your total or gross income, deduct certain expenses to get a number called your adjusted gross income (AGI) and then subtract even more deductions and exemptions to arrive at your taxable income.

To figure out your total income, you need to add up everything that could possibly be considered earnings. The first major income category is wages, salaries and tips. If you work for someone else, you will receive a W-2 form in February that lists your total salary, wages and tips for the year. If you are an independent contractor, you will receive a 1099 form from your clients with income listed under "nonemployee compensation." If you're self-employed, keep track of your own earnings or losses and enter them in Schedule C of the 1040.


Then there's every other type of income. If you collected interest or dividends on investments like stocks, CDs or money market accounts, you need to report that as income. If you sold stock, real estate or collectibles for a profit, then you need to report that income as a capital gain. Alimony, pensions, annuities, farm income, royalties and trusts , even your Social Security benefits -- the IRS wants a piece of it all. (The only tax-exempt income is unemployment compensation up to $2,400 a person [source: IRS].) Add all of these earnings together to get your total income.

The adjusted gross income is your total income minus a few specific deductions. Some examples are self-employment tax (you can deduct half of the amount from your total income), moving expenses, certain health care costs, student loan interest, tuition and alimony. Add those together and subtract them from the total income to calculate your AGI.

To arrive at your taxable income, you need to subtract deductions and exemptions. Many people take the standard deduction, which is a lump sum based on your filing status. Other people itemize their deductions, submitting receipts for every major and minor qualifying expense. The IRS only cares about the higher number.

Everybody is entitled to at least one personal exemption, valued at $3,650. But you can also claim exemptions for your spouse and qualifying dependents. A family of four can deduct $14,600 from their AGI. Once you subtract exemptions and deductions from your AGI, you're left with your taxable income. This is the number you plug into the Tax Tables to figure out how much you owe in federal income tax.