As we go down Form 1040 in your personal tax returns, we talked about Total Income and Adjusted Gross Income in the last couple of weeks. Today, we move on to the most important one- Taxable Income.
In brief, Total Income is just that. All your income from employment or business, as well as investments- all income flowing to you from different sources.
On that Total Income, you get to take out some stuff- those are called Adjustments to your income. They are listed on Schedule A. For instance, if you contribute to a retirement plan through your pass-through business, or to an HSA. Or if you are eligible to deduct your IRA contribution. Or the deductible part of your Self-Employment Taxes, if you are self-employed.
Take these out from your Total Income and you are left with your AGI: Adjusted Gross Income.
The AGI is important because it decides your eligibility for different tax credits and impact your itemized deductions.
Once you factor in Itemized or Standard deductions and Qualified Business Income Deduction in your AGI, you get to taxable income.
AGI – Standard/Itemized Deduction – Qualified Business Income Deduction = Taxable Income
Standard Deduction
This is the default option if you choose not to itemize your deductions.
The standard deduction was doubled in 2017 by the Tax Cuts and Jobs Act to $12,400 per person. This is currently set to expire at the end of 2025.
It goes on line 9 of Form 1040.
Your standard deduction depends on:
- Age: more if your spouse or you are over 65 years of age
- Filing status: it is doubled for married filing jointly and qualifying widow(er)s. And midway between the two numbers for heads of household.
- And for those who are blind.
Not everyone is eligible to claim the standard deduction. If you are a non-resident alien, that is, you are in the US on a visa, you cannot claim it. Also, if you are married filing separately, and your spouse is itemizing their deductions, you have to do the same.
Itemized Deductions
If you think the total of your Itemized Deductions is more than $12,400 (or $24,800 for those married filing jointly), you will want to itemize your deductions on Schedule A of Form 1040.
Since the passage of the Tax Cuts and Jobs Act, for years 2018 and beyond, the total amount of your itemized deductions is not limited by your AGI.
This total amount of itemized deductions goes on line 9 of Form 1040.
Let’s go over the list:
Medical and Dental Expenses
- Medical and dental expenses borne by you and not reimbursed by an employer or others, is an itemizable deduction.
- This includes health insurance premiums and some part of the premiums for long-term care.
- However, the expenses must be at least 7.5% of your Adjusted Gross Income to be deductible., and that’s a fairly high floor for high-earners.
- Any pre-tax insurance premiums you receive as an employee is not included since that doesn’t figure in your W2 income.
- If you are self-employed and pay for your health insurance via your business, you have taken that as a deduction on Schedule 1, line 16- so you cannot take it again on Schedule A.
State and Local Taxes
- You may elect to deduct either state and local income tax or general sales tax, but not both.
- State and local income taxes are stated on your W2.
- State and local general sales tax may either be based on actual expenses or from estimates given by IRS.
- State and Local Real Estate Taxes on any property not used as a business, that is, your home and vacation home.
- State and local taxes on personal property, based on value: for example- the part of your car’s annual registration fee based on its value.
- The total of State and Local taxes has now been reduced to $10,000. So most of us, either in high income tax states or with high property taxes, get to deduct only a small part of it.
Interest Paid
- Most of this section refers to home mortgage interest.
- Only property used for personal purposes are included here. You may be able to deduct interest and other expenses on business or investment property in other parts of your tax return.
- If you paid points at closing, that will be on your settlement statement and is deductible either in the year it was paid (as long as certain criteria are met) or over the life of the loan. The points should have been made towards loan expenses, rather than lender fees.
- If you got your mortgage in 2018 or after, the maximum loan amount on which you can deduct interest, is $750,000.
- If your mortgage originated in 2017 or earlier, you are grandfathered (grandparented?) into a maximum loan amount of $1Million.
- If you have Private Mortgage Insurance (PMI)- usually for a non-physician loan with a downpayment less than 20%- that is now deductible, too, since 2018. Unfortunately, you do not qualify if your AGI is greater than $109,000 (married filing jointly)- and hence is not applicable to most physicians.
- If you borrowed money to invest- such as a mortgage on an investment property or invested on margin in a brokerage account- the interest on that loan may be deductible. There are a variety of limitations on this deduction. It is limited to the amount of income generated from the investment in the year, though it may be carried forward. It does not include passive activity, such as a rental property.
Charitable Contributions
- Gifts made to qualified charitable organizations are deductible on Schedule A, if you itemize.
- The organization should be able to tell you if they qualify. The IRS also maintains a list of qualifying institutions. Foreign charitable organizations are not included.
- Contributions may be in cash or kind. You are required to estimate a fair value for your in-kind contributions.
- Cash contributions are usually deductible up to 60% of your AGI. However, the CARES Act temporarily suspends this limitation- and you can deduct up to 100% of AGI for cash contributions.
- If you volunteer your time to a charity, you could deduct the out-of-pocket expenses you incurred- such as gas mileage (at 14 cents a mile), tolls, parking, etc. You cannot deduct the value of your time.
- For contributions more than $250, you need a receipt from the charity that you keep for your records.
- For contributions more than $500, you attach Form 8283 to your tax returns. For donations of more than $5000, excluding donations of publicly-traded securities, you may need an appraisal.
- Generally, you are able to deduct up to 50% of your AGI but in some cases, the limit may be 20-30%, depending on the type of charitable organization. You may be able to cary forward these deductions in a future year, if you hit your limit for a certain year.
Other Itemized Deductions
There are certain other esoteric deductions you can take. This includes theft and casualty losses, gambling losses (only to offset any wins) and a bunch of others.
Qualified Business Income Deduction
This is also known as Section 199A deduction, introduced in the Tax Cuts and Jobs Act of 2017.
If applicable, it goes on line 10 of Form 1040.
It is a complex topic, with many nuances. In brief:
- If you own a business as a sole proprietorship, partnership or an S-corp, you may be able to deduct up to 20% of your net business income or profit.
- This does not include any W2 wages you receive from your S-corp.
- There are certain specified service-related trades and businesses (SSTB)- including doctors, lawyers and accountants- who are eligible to take the QBI deduction only if their taxable income, before QBI, is less than a certain threshold. The threshold is from $163,300 to $213,300 for individual filers and from $326,600 to $426,600 for married filing jointly, in 2020. It is annually adjusted for inflation.
- Irrespective of the nature of the business, if the taxable income of the business owner is above those thresholds, there is yet another limitation. It takes into account either 50% of the wages the business pays its employees or 25% of employee wages + 2.5% of the basis of any property owned by the business. The deduction is then the lesser of the deduction is the lesser of 20% of QBI or 50% of employee wages (or 25% of employee wages + 2.5% of property basis).
This is it, in a nutshell. Reams have been written about it. And there are many variations in every taxpayer’s situation, affecting things. The White Coat Investor has written a few good articles about it- this is one.
Calculating Taxable Income
You add up lines 9 (Standard or Itemized Deductions) and 10 (Qualified Business Income Deduction) on line 11a of Form 1040.
You then subtract this total from Adjusted Gross Income on line 8b. This gives you your Taxable Income on line 11b of Form 1040.
This is the end of page 1 of Form 1040. Page 2 is all about the different taxes you have to pay. We’ll get to that another day.
Thank you for reading. I hope it clarifies some things for you!
As always, I want to point out, by way of disclaimer, that this is all for general information and that I am in no way qualified to give professional accounting, tax or financial advice.