To most taxpayers, taxes and how they’re calculated are a mystery. Consisting of 70,000+ pages, the Internal Revenue Code (aka, the Commerce Clearing House [CCH] Standard Federal Tax Reporter) is complicated, and when you’re filling out the forms (on paper, online, or in a tax program), determining what you’re being asked and how to supply the correct information can be both challenging and frustrating. Every so often, a politician expresses a vision of a time when our tax returns will fit on a postcard, but that never happens. (As an aside, the shortened version was attempted with the 2018 tax year and was an unmitigated disaster — the result… the tax return went from two pages to eight pages. In 2019, it was shortened to five pages. Simple, right!?)

Fortunately, people like me who’ve spent five years in college studying accounting and taxes, and countless hours since leaning about the practical application of Title 26 of the United States Code (i.e., the Internal Revenue Code), are available to help you navigate this minefield. We’ve been trained to quickly analyze taxable situations, however simple or complex, and complete our clients’ returns in a way so as to minimize their tax burden.

Still, you can benefit by understanding the fundamentals of how tax bills are calculated. In this post, I explain the process in plain and simple terms.

Seven Steps to Calculate Your Tax Bill

Calculating your tax bill is a seven-step process. Here I present the overall process and then take a deeper dive into each step. Before going there, however, below is a 30,000-foot overview of the seven-step process to calculating your tax bill:

While that may sound like a lot of gibberish to you, to someone like me, it’s music to my ears. Starting with Step No. 1, here’s the deeper dive I promised:

Step 1: Calculate total income

The IRS wants to know how much money you have received over the course of the year — your total income. Total income includes money received from the following sources:

Earned income from wages, salaries, commissions, and tips
Profits from business and self-employment
Interest and dividends
Capital gains from the sale of property held for investment
Income from pensions, IRAs, and annuities
Rents, royalties, and income from flow-through entities
Alimony (from agreements finalized before January 1, 2019)
Gambling winnings
Barter proceeds
Illegal income (yes, you’re required to disclose income from illegal activities)

Income from certain sources is generally tax exempt, although you may still be required to report it, including the following:

Gifts and inheritances
Most employee benefits
Most life insurance proceeds
Municipal bond interest income (however, this could affect Alternative Minimum Tax — a tax imposed by the federal government in addition to the regular income tax for certain individuals, estates, and trusts)
IRA rollovers
Property settlements as a result of divorce
Child-support payments
Proceeds from workers’ compensation
Disability insurance proceeds (if you paid premiums yourself)
Federal tax refunds
State tax refunds (if you didn’t previously itemize the taxes paid)
Most scholarships and fellowships

Step 2: Subtract adjustments to income to calculate Adjusted Gross Income (AGI)

Adjustments to income are primarily qualified expenses and retirement savings that reduce the actual amount of money you received and have available to spend. Qualified adjustments to income include the following:

Educator (teacher) expenses
Certain business expenses of reservists, performing artists, and fee-basis government officials
IRA and self-employed retirement plan contributions
Job-related moving expenses (for active-duty military personnel only)
One-half of any self-employment tax
Self-employed health insurance
Penalty on early withdrawal of savings (for example, cashing in a CD early)
Alimony you pay (for agreements finalized before January 1, 2019)
Student loan interest
College tuition and fees
Health Savings Account (HSA) contributions

After subtracting these amounts from your total income, what remains is your Adjusted Gross Income (AGI)

Step 3: Subtract deductions from AGI

Deductions further reduce the amount of income taxed. In this step, you have a choice: you can take the standard deduction or itemize your deductions. The standard deductions for 2020 are as follows:

Single or married filing separately: $12,400
Head of household: $18,650
Married couple filing jointly: $24,800
If you’re 65 and older, or if you’re legally blind, you can add another $1,300 per person to the standard deduction (i.e., for a single person 65-years-old or older, that would be $13,700)

If itemized deductions exceed the standard deduction for which you qualify, you can save money by itemizing. Itemizing consists of calculating the total of qualified expenses, which include the following, and subtracting it from your adjusted gross income (AGI):

Medical and dental expenses over 10 percent of AGI
State and local income, sales, and property taxes, up to $10,000
Foreign taxes
Mortgage interest
Casualty and theft losses incurred as a result of federally declared disasters (over $100 plus 10 percent of AGI)
Charitable gifts

Regardless of whether you claim the standard deduction or itemize your deductions, if you are the owner of a sole proprietorship, S corporation, trust or qualifying estate, you may be eligible for the Qualified Business Income Deduction (QBID), as well. This deduction allows eligible taxpayers to deduct up to 20 percent of their qualified business income (QBI), plus 20 percent of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income.

After you subtract deductions from AGI, the result is your taxable income.

Step 4: Multiply taxable income by the tax rate(s) for your tax bracket(s)

Tax calculation becomes somewhat more complex at this step, because your total income can fall into several buckets with the amount in each bucket taxed at a different rate. For example, suppose you’re filing jointly, and you and your spouse together have $120,000 in taxable income. The 2020 federal income tax brackets look like this:

Rate	For Single Individuals, Taxable Income Over	For Married Individuals Filing Joint Returns, Taxable Income Over	For Heads of Households, Taxable Income Over
10%	$0	$0	$0
12%	$9,875	$19,750	$14,100
22%	$40,125	$80,250	$53,700
24%	$85,525	$171,050	$85,500
32%	$163,300	$326,600	$163,300
35%	$207,350	$414,700	$207,350
37%	$518,400	$622,050	$518,400
Source: Internal Revenue Service

But wait; you’re not done yet. You may qualify for one or more tax credits, which reduce the amount you pay.

Step 5: Subtract any eligible tax credits

While tax deductions reduce the amount of income used to calculate the tax owed, credits come directly off the bottom line — the total tax you owe. They are a dollar for dollar reduction of your tax bill. As accountants and taxpayers, we love tax credits. All credits can be used to reduce your tax bill, some credits, such as the dependent care credit, are also refundable. Some credits must be used in the current year (dependent care credit), whereas others carry forward in perpetuity until used (energy credits).

Here are some of the most common credits you may be able to subtract from your tax bill:

Adoption Tax Credit
Child & Dependent Care Credit
Earned Income Tax Credit
Elderly and Disabled Tax Credit
Education Credits
Retirement Savers Credit

Credits for investors include:

Foreign Tax Credit
Low-Income Housing Tax Credit
Rehabilitation Credit

Finally, the General Business Credit includes credits for a variety of expenses, including:

Alcohol fuels
Disabled access
Employer-provided childcare
Rehabilitation, energy, and reforestation investments
Qualified research expenses
Small employer pension plan startup costs
Work opportunity and welfare-to-work expenses

Step 6: Add any other taxes

In this step, you are adding in any other taxes that you might owe, such as these:

Alternative Minimum tax (AMT)
Self-employment taxes
Additional tax on IRAs, qualified plans
Household employment taxes
First-time homebuyer credit repayment
Other taxes

Step 7: Subtract any income tax already paid

If you had any taxes withheld or paid any income taxes, such as estimated taxes, and had them applied to the tax year for which you are filing, subtract them from the result in Step 6. This final number represents your tax bill (or refund).

Now wasn’t that easy?

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About the Author: Laura Stees, CPA is a Partner and Business Strategist with Stees, Walker & Company LLP — a San Diego, Calif.-based boutique tax consulting firm focused on personalized tax and financial guidance to individuals and businesses.

Disclaimer: The information in this blog post about calculating your tax bill is provided for general informational purposes only and may not reflect current financial thinking or practices. No information contained in this post should be construed as financial advice from the staff at Stees, Walker & Company LLP, nor is this the information contained in this post intended to be a substitute for financial counsel on any subject matter or intended to take the place of hiring an Certified Public Accountant in your jurisdiction. No reader of this post should act or refrain from acting on the basis of any information included in, or accessible through, this post without seeking the appropriate financial planning advice on the particular facts and circumstances at issue from a licensed financial professional in the recipient’s state, country or other appropriate licensing jurisdiction.