Albert Einstein once said that the hardest thing in the world to understand is income tax, so you’d be forgiven for feeling a bit lost when tax season rolls around. But understanding the basics of how your taxes work can make a real difference—not just in what you owe, but in how confident you feel throughout the process.

At its core, federal income tax calculation follows a straightforward formula:

Gross Income – Adjustments = Adjusted Gross Income (AGI)
AGI – Deductions = Taxable Income
Taxable Income – Credits = Final Tax Liability

Don’t worry if this doesn’t all click just yet. Think of this formula as a guide you can refer back to as you work through each part of your return, helping you see where you are in the overall process. Each part represents a critical stage where income, adjustments, deductions, and credits operate together to determine your final tax obligation. Throughout this guide, we’ll break down each of these steps in a manageable way so that you can tackle each part with clarity. 

Start with Gross Income 

Under the Internal Revenue Code (IRC) §61, the IRS defines gross income as “all income from whatever source derived.” This broad definition means that nearly everything counts as taxable income—wages, investments, side gigs, and even illegal income (yes, drug money included!). That said, they’re categorized in distinct ways on your tax return:

• Wages, Salaries, and Tips: Most people earn their primary income from employment, which is reported on W-2 forms. This type of income is fully taxable and forms the foundation of gross income. Your employer will withhold taxes from your paycheck throughout the year, which helps cover your tax liability.
• Self-Employment Income: Freelancing, running a business, or side hustles also count as gross income. These earnings are reported on Schedule C, which captures the net profit or loss from self-employment activities. Note: being self-employed also means you are responsible for both income tax and self-employment tax, which covers Social Security and Medicare (more on that later).
• Investment Income: Investment income includes interest, dividends, and capital gains, each of which has different tax treatments. Interest income is taxed at ordinary rates, while qualified dividends and long-term capital gains often receive favorable rates if the holding period requirements are met. Investment income can also include rental income, royalties, and income from other passive activities, which must be reported on various schedules depending on the income’s source (this is further discussed in detail below).

Apply Adjustments to Calculate Your AGI

Once you’ve determined your total income, the next step is to calculate your AGI by applying adjustments, which can be thought of as certain essential expenses that the IRS allows you to subtract before reaching the stage of deductions. Common adjustments include: 

• Traditional IRA Contributions: Contributions to a traditional IRA are deductible if you meet income requirements. This reduces your AGI while helping you save for retirement. Note that the benefit phases out at higher incomes, especially if you’re covered by an employer-sponsored plan. Traditional IRA contributions can be a valuable way to reduce your taxable income while planning for your future.
• Health Savings Accounts (HSAs): HSAs can provide a triple tax benefit in that contributions reduce your AGI, earnings grow tax-free, and withdrawals for qualified medical expenses are also tax-free. For these reasons, HSAs are often considered one of the most tax-efficient savings vehicles available, as they offer tax benefits during every stage—contribution, growth, and withdrawal.
• Self-Employment Tax Deduction: People who are self-employed must pay both the employee and employer portions of Social Security and Medicare taxes. However, you can deduct half of this tax when calculating AGI, which helps offset the higher tax burden. This deduction can significantly reduce the effective tax rate for self-employed individuals.
• Student Loan Interest Deduction: You may be able to deduct up to $2,500 of student loan interest, provided your income is below a certain threshold. This adjustment not only reduces your AGI but may also make you eligible for other tax benefits.

Note: You may also need to determine your Modified Adjusted Gross Income (MAGI), depending on the tax credits or deductions you are interested in. MAGI is an adjusted version of your AGI that adds back certain deductions, such as foreign-earned income and tax-exempt interest. MAGI was not included in the formula at the head of this guide on how your income taxes are calculated because, unlike AGI, it doesn’t directly affect your taxable income or final tax liability; instead, it acts as a threshold for qualifying for certain tax benefits including Roth IRA contributions and certain education credits.

Apply Deductions

After calculating your AGI, the next step is to apply deductions to determine your taxable income. There are two types of deductions available:

• Standard Deduction: This is a fixed deduction amount based on your filing status and is available to all taxpayers. It simplifies filing since you don’t need to track specific expenses. For 2024, the standard deduction amounts are $14,600 for single filers, $29,200 for married couples filing jointly, and $21,900 for head-of-household filers. The standard deduction is typically the best choice for those with moderate incomes or without significant deductible expenses.
• Itemized Deductions: Itemizing allows you to claim specific expenses individually, which may result in a larger deduction if you have significant qualifying expenses. Common itemized deductions include:
  • Mortgage Interest: Interest paid on a mortgage for your primary residence, up to a certain limit. This deduction can provide significant tax savings for homeowners, particularly in the early years of a mortgage when interest payments are higher.
  • State and Local Taxes (SALT): Property taxes, state and local income or sales taxes, capped at $10,000. The SALT deduction can be particularly important for taxpayers in states with high income or property taxes, although the cap limits the potential benefit for many.
  • Medical Expenses: Out-of-pocket medical costs and expenses for doctor visits, prescription medications, and even some long-term care expenses, that exceed 7.5% of your AGI.
  • Charitable Contributions: Donations to qualified charitable organizations, are subject to limits based on your income. Note that charitable contributions can include not only cash donations, but also the fair market value of goods donated. 

Your decision between the standard deduction and itemizing depends on your financial situation. Broadly speaking, the standard deduction is best for taxpayers who don’t have significant deductible expenses. It’s straightforward, requires no documentation, and is often the best option for those with moderate incomes. However, if your qualifying expenses surpass the standard deduction, itemizing could offer a better outcome. While it requires keeping detailed records, the potential tax savings may be worth the effort, especially for those with high medical expenses, mortgage interest, or charitable contributions. For instance, homeowners with substantial mortgage interest or individuals who donate significantly to charity may find that itemizing offers greater savings than taking the standard deduction.

Utilizing Tax Credits

Once you have calculated your AGI and applied deductions, the next major step is to determine your tax credits. Unlike deductions, which reduce the income subject to tax, credits reduce the actual amount of tax you owe. There are two main types of credits—nonrefundable (which can reduce your tax liability to zero but cannot create a negative tax balance, meaning you won't receive a refund if they exceed your tax owed) and refundable (which can reduce your tax liability below zero, allowing you to receive a refund for the difference). Here are some of the most common tax credits that can help reduce your tax bill:

• The Earned Income Tax Credit (EITC): The EITC is designed to benefit low-to-moderate income earners. The amount of the credit depends on your income level and the number of qualifying dependents you have. Because it is refundable, the EITC can result in a significant refund even if your tax liability is reduced to zero.
• The Child Tax Credit (CTC): For the 2024 tax year, the CTC allows eligible taxpayers to reduce their tax liability by up to $2,000 per qualifying child. Additionally, a portion of this credit is refundable; specifically, up to $1,700 per child can be refunded if the credit exceeds your tax liability
• Education Credits: Education credits, such as the American Opportunity Credit and the Lifetime Learning Credit, can help offset the cost of higher education. The American Opportunity Credit is partially refundable and is available for undergraduate education expenses. The Lifetime Learning Credit is nonrefundable and can be used for a broader range of educational expenses, including graduate programs and continuing education.
• The Saver’s Credit: The Saver’s Credit is designed to encourage low-to-moderate income earners to contribute to retirement savings accounts. It provides a credit based on a percentage of contributions made to an IRA, 401(k), or similar retirement plan, and the amount of the credit depends on your income and filing status.

Tax Forms and Schedules  

Now that we’ve explored the core components of federal income tax—gross income, adjustments, deductions, and credits—let’s see how they come together in Form 1040, the central document for your individual tax return, where each section of the form ties directly to a step in the walkthrough we’ve built, making it easier to see how the pieces fit together and guide you from start to finish.

1. Reporting Gross Income: As discussed above, the IRS requires that you report income from nearly every source, whether it’s wages, self-employment earnings, or investment profits. On Form 1040, gross income is captured in its simplest form and expanded as needed using supporting schedules as follows:

• Wages and Salaries: Reported on Form W-2 from your employer. This form provides details on your earned income and the taxes withheld from your paycheck.
• Self-Employment Income: Reported using Schedule C. This includes net earnings from freelancing, side hustles, or any business operations you run independently. For nonemployee compensation, such as freelance income, you'll also need Form 1099-NEC to document this income.
• Investment Income:
  • Interest and Dividend Income: If you receive interest income from savings or investments, or dividends from stocks, this information is reported on Schedule B if certain thresholds are exceeded. Supporting forms include Form 1099-INT for interest income and Form 1099-DIV for dividends.
  • Capital Gains and Losses: If you sold stock, bonds, or real estate, the gains or losses are reported on Schedule D. You will need Form 1099-B to detail proceeds from broker and barter exchanges.
• Rental and Supplemental Income: Income from rental properties, royalties, trusts, or other supplemental income sources is reported on Schedule E

2. Applying Adjustments to Income: Next, you’ll calculate your AGI by subtracting certain allowable adjustments from your gross income. Adjustments, as covered earlier, help lower your taxable income and determine eligibility for key tax benefits.

Note: In Form 1040, these adjustments are captured in a dedicated section, often pulling information from Schedule 1 (which includes additional income and certain details pertaining to adjustments).

3. Choosing Deductions to Arrive at Taxable Income: Once your AGI is calculated, the next step is to determine your taxable income by choosing between the standard deduction and itemized deductions.

For the standard deduction, no additional documentation is required—simply use the amount specified for your filing status (e.g., single, married filing jointly, head of household) on Form 1040.

For itemized deductions, include records of deductible expenses, such as:

• Form 1098 for mortgage interest.
• Property tax statements or records of SALT payments, capped at $10,000.
• Receipts for charitable donations, including cash contributions and the fair market value of donated goods.
• Medical bills and statements for expenses exceeding 7.5% of your AGI.

4. Calculating Taxes and Claiming Credits: With your taxable income determined, Form 1040 calculates your tax liability by applying the relevant tax rates. Then, you’ll incorporate any eligible tax credits, which, as discussed earlier, can be either nonrefundable or refundable. Relevant forms and documentation can include:  

• Form 1098-T for education expenses and records of retirement contributions
• Childcare expense documentation for the Child and Dependent Care Credit.
• Proof of earned income (e.g., W-2 or 1099-NEC) for the EITC.
• Adoption expense records, if claiming the Adoption Tax Credit.
• Statements from retirement plans or IRAs for the Saver’s Credit.
• Records of energy-efficient home improvements for energy credits. 
• Any additional forms or receipts related to credits you plan to claim

5. Reconciling Payments and Refunds: The final step on Form 1040 is reconciling your tax liability with payments already made through withholding (reported on your W-2) or estimated payments. Relevant forms and documents include: 

• Form W-2 to report taxes withheld by your employer.
• 1099-NEC or 1099-MISC for income without withholding (e.g., freelance work).
• Records of estimated quarterly tax payments you’ve made.
• Form 1099-G for refunds, credits, or offsets from state and local taxes.
• Bank account details for direct deposit of your refund (optional but recommended).
• Any correspondence from the IRS or prior payments applied to your account, if relevant.

Note: 1099 forms appear both in Steps 1 and 5 (for reporting income and reconciling taxes, respectively) because they serve multiple purposes in the tax filing process—first, to report various types of income you received during the year, and later, to reconcile any tax withholdings or credits related to that income.

Dates For Filing Your Return And Making Estimated Payments (if applicable) 

Your Form 1040 individual income tax return is due by April 15 following the tax year. If you need additional time to prepare your tax return, you can request an automatic 6-month extension by filing Form 4868 by April 15. This extension provides more time to file your return—until October 15—but it does not extend the time to pay any tax due. If you expect to owe taxes, you must estimate and pay the amount due by April 15 to avoid penalties and interest.

If you earn income that isn’t subject to withholding, such as self-employment income or investment income, you may need to make quarterly estimated tax payments to the IRS. Below are the standard due dates for estimated payments:

• 1st Quarter (January 1 - March 31): April 15
• 2nd Quarter (April 1 - May 31): June 15
• 3rd Quarter (June 1 - August 31): September 15
• 4th Quarter (September 1 - December 31): January 15 of the following year

Note: If a specific tax deadline falls on a weekend or legal holiday, it will automatically be extended to the next business day. For example, if April 15 falls on a Saturday, you would have until Monday, April 17 to file your tax return or make any required payments.

As you can see, filing your federal income taxes requires careful consideration of income, deductions, credits, and additional payments to ensure accuracy and avoid costly mistakes. Tax regulations are complex, and a knowledgeable attorney can provide valuable guidance to help you navigate the process, maximize eligible deductions and credits, and address any questions or complications. Through AAL’s directory, you can connect with experienced tax attorneys who are skilled in assisting individuals with tax preparation and planning, ensuring compliance and peace of mind.