There are basic steps in calculating federal income taxes

1. Determine Your Total Income
Practically everything you receive in return for your work or services and any profit from the sale of assets is considered income, whether the compensation is paid in cash, property, or services. Listing these earnings will reveal your total income compensation from all sources and much of it, but not all, will be subject to income taxes.

Income to Include For most people, earned income is reported to them annually on a Form W-2, Wage and Tax Statement. Employers must provide W-2 information (see Figure 4.3) by January 31 of the next year. If you receive income from interest or dividends or other sources, those sources may send you a Form 1099. All this information is provided to the IRS.

The following types of income are included when you report your income to the IRS:

Wages and salaries
Commissions
Bonuses
Professional fees earned
Income from stock options
Tips earne
Fair value of anything received in a barter arrangemen
Alimony received
Scholarship and fellowship income spent on room, board, and other living expenses
Grants and the value of tuition reductions that pay for teaching or other services
Annuity and pension income received
Withdrawals and disbursements from retirement accounts, such as an individual retirement account (IRA) or 401(k) retirement plan
Withdrawals from retirement accounts and tax-deferred annuities
Military retirement income
Social Security income (a portion is taxed above certain income thresholds)
Disability payments received if you did not pay the premiums
Damage payments from personal injury lawsuits (punitive damages only)
Value of personal use of employer-provided ca
State and local income tax refunds (only if the taxpayer itemized deductions during the previous year
Employee productivity awards
Awards for artistic, scientific, and charitable achievements unless assigned to a charit
Prizes, contest winnings, and rewards
Gambling and lottery winnings
All kinds of illegal income
Fees for serving as a juror or election worker
Unemployment benefit
Partnership income or share of profit
Net rental income
Royalties
Investment, business, and farm profits
Interest income (this includes credit union dividends)
Dividends from mutual funds (including capital gains distributions even though they are reinvested)
Dividend income

Include Capital Gains and Losses in Total Income An asset is property owned by a taxpayer for personal use or as an investment that has monetary value. Examples of assets include stocks, mutual funds, bonds, land, art, gems, stamps, coins, vehicles, and homes. The net income received from the sale of an asset above the costs incurred to purchase and sell it is a capital gain. A capital loss results when the sale of an asset brings less income than the costs of purchasing and selling the asset. Capital gains and losses on investments must be reported on your tax return. Capital gains from the sale or exchange of property held for personal use, such as on a vehicle or vacation home, must be reported as income, but losses on such property are not deductible. There is no tax liability on any capital gain until the stock, bond, mutual fund, real estate, or other investment is sold.

short-term gain (or loss) occurs when you sell an asset that you have owned for one year or less; it is taxed at the same rates as ordinary income. A long-term gain (or loss) occurs when you sell an asset that you have owned for more than one year (at least a year and a day), and it is taxed at special low rates. Long-term capital gains are taxed at a maximum rate of 15 percent, and the rate is only 5 percent for taxpayers in the lower two brackets (15 and 10 percent). Capital losses may be used first to offset capital gains. If there are no capital gains, or if the capital losses are larger than the capital gains, you can deduct the capital loss against your other income, but only up to a limit of $3000 in one year. If your net capital loss is more than $3000, the excess carries forward to the next tax year, up to an annual $3000 maximum.

2. Determine and Report Your Gross Income After Subtracting Exclusions
Gross income consists of all income (both earned and unearned) received in the form of money, goods, services, and property that a taxpayer is required to report to the IRS. To determine gross income, you need to determine which kinds of income are not subject to federal taxation and, therefore, need not be reported as part of gross income. These amounts are called exclusions

Income to Exclude The more common exclusions (some are subject to limits) are as follows:

Gifts
Inherited money or propert
Income from a carpoo
Income from items sold at a garage sale for a sum less than what you pai
Cash rebates on purchases of new cars and other products
Tuition reduction, if not received as compensation for teaching or servic
Federal income tax refunds
State and local income tax refunds for a year in which you claimed the standard deduction
Scholarship and fellowship income spent on course-required tuition, fees, books, supplies, and equipment (degree candidates onl
Withdrawals from state-sponsored Section 529 plans (prepaid tuition and savings) used for education
Prizes and awards made primarily to recognize artistic, civic, charitable, educational, and similar achievements
Return of money loaned
Withdrawals from medical savings accounts used for qualified expenses
Earnings accumulating within annuities, cash-value life insurance policies, Series EE bonds, and qualified retirement account
Interest income received on tax-exempt government bonds issued by states, counties, cities, and district
Life insurance benefits received
Combat zone pay for military personnel
Welfare, black lung, workers’ compensation, and veterans’ benefits
Value of food stamps
First $500,000 ($250,000 if single) gain on the sale of a principal residence
Disability insurance benefits if you paid the insurance premiums
Social Security benefits (except for high-income taxpayers)
Rental income from a vacation home if not rented for more than 14 days
First $5000 of death benefits paid by an employer to a worker’s beneficiary
Travel and mileage expenses reimbursed by an employer (if not previously deducted by the taxpayer)
Employer-provided per diem allowance covering only meals and incidentals
Amounts paid by employers for premiums for medical insurance, workers’ compensation, and health and long-term care insuranc
Moving expense reimbursements received from an employer (if not previously deducted by the taxpayer)
Employer-provided commuter highway vehicle transportation and transit passes (up to $110 per month for both) and parking (up to $215 per month)
Value of premiums for first $50,000 worth of group-term life insurance provided by an employer Employer payments (up to $5000) for dependent care assistance (for children and parents)
Benefits from employers that are impractical to tax because they are so modest, such as occasional supper money and taxi fares for overtime work, company parties, holiday gifts (not cash), and occasional theater or sporting events
Employee contributions to flexible spending accounts
Reimbursements from flexible spending accounts
Reimbursements for medical expenses from health reimbursement accounts funded solely by employer contribution
Employer-provided educational assistance payments for undergraduate and graduate classes (up to $5250 annually
Interest received on Series EE and Series I bonds used for college tuition and fees
Child support payments received
Property settlement in a divorc
Compensatory damages in physical injury cases

3. Subtract Adjustments to Income
In the process of determining your taxable income, you make adjustments to income (or adjustments). These allowable subtractions from gross income include items such as moving expenses to a new job location (including college graduates who move to take their first job); higher-education expenses for tuition and fees (up to $4000); student loan interest for higher education ($2500 maximum); reservists’ travel expenses (for more than 100 miles); contributions to qualified personal retirement accounts [IRA and 401(k)

accounts and health savings accounts; alimony payments; interest penalties for early withdrawal of savings certificates of deposit; business expenses; net operating losses; capital losses (up to $3000); and certain expenses of self-employed people (such as health insurance premiums). Adjustments are subtracted from gross income to determine adjusted gross income (AGI). Subtracting adjustments to income from gross income = results in a subtotal.

To illustrate the value of adjustments to income, consider a person with a gross income of $41,000 who contributes $1000 to certain types of qualified retirement accounts (plans that the IRS has approved to encourage saving for retirement). The adjustment reduces gross income to $40,000 and, therefore, saves $250 in income taxes (calculated using Table 4.2).