What Gets Taxed

Richard Connor

INCOME SHOULD BE ONE of the simplest concepts in financial planning—and yet it turns out to be one of the most confusing, thanks to the multiple ways it’s calculated depending upon whether it applies to income taxes, Social Security and so on. My goal today: Help you sort out income’s shifting definition across the U.S. tax code.

Gross income. This is the granddaddy—income from all sources, before almost any taxes or deductions. For an individual, this includes wages and salary, pensions, interest, dividends, tips, capital gains, alimony and rental income. It can also include up to 85% of a retiree’s Social Security benefits, as we’ll see later.

Adjusted gross income. Commonly called AGI, this is gross income minus certain adjustments, such as up to $300 in educator expenses for teachers, student loan interest, alimony payments and contributions to retirement accounts. AGI determines eligibility for some tax deductions and credits.

Modified adjusted gross income. MAGI is widely used to determine tax eligibility for such things as IRA contributions and the child tax credit, to name just two. For many folks, AGI and MAGI are almost identical because their adjustments to income are little to none.

Unfortunately, the IRS calculates MAGI in multiple ways depending on the deduction or credit in question. Here are some of the most widely used formulas:

  • The MAGI for the Affordable Care Act health insurance subsidy is AGI plus any untaxed foreign income, nontaxable Social Security benefits and tax-exempt interest from investments like municipal bonds.
  • The MAGI for the child tax credit, the American Opportunity tax credit for higher education costs and the student loan interest deduction is AGI plus some sources of foreign income.
  • The MAGI for the adoption tax credit is AGI plus tax-exempt interest and some sources of foreign income.
  • The MAGI for Medicare premium surcharges is AGI plus tax-exempt interest income. These surcharges are also known as the income-related monthly adjustment amount, or IRMAA. Medicare uses your income from two years ago to determine if you must pay higher Medicare premiums this year.

Taxable income. This is the bottom line number you plug into the income tax table to see how much you owe Uncle Sam. It’s AGI minus any allowable tax deductions.

For most paycheck workers, their income number is provided on the W-2 form their employer sends after year-end. If you’re self-employed, keeping track of your income and deductible expenses is much more complicated. The IRS provides these guidelines for what is and isn’t considered taxable income, but it doesn’t make for easy reading.

Meanwhile, taxpayers can take one of two paths to determine their tax deductions. They can either claim the standard deduction—$13,850 for single tax filers in 2023 and $27,700 for couples filing jointly—or itemize their specific deductions. Itemized deductions include the basics like mortgage interest paid, charitable deductions, and state and local taxes, as well as more esoteric expenses.

Social Security. This is another whole can of worms. During our working years, there’s a couple of taxable income figures worth knowing. The maximum taxable earnings amount on which you pay payroll taxes is $160,200 in 2023. Once you surpass this amount, you no longer owe the 6.2% Social Security tax. You’re still on the hook for the 1.45% Medicare tax, however, since it has no upper limit.

If you collect Social Security benefits before full retirement age and continue to work for pay, your benefits can be reduced based on your income. If you’re younger than your full retirement age for the entire year, Social Security will deduct $1 in benefits for every $2 you earn above $21,240 in 2023.

In the year you reach your full retirement age, Social Security will deduct $1 in benefits for every $3 of earnings above $56,520 in 2023 until the month that you reach your full retirement age. After that, you can earn any amount with no reduction in benefits.

But hold on, we’re not quite done with Social Security. A portion of your benefit payments may be taxed based on yet another definition of income. This one is called combined income, and it’s your adjusted gross income plus any nontaxable interest income and one-half of the Social Security benefits you receive.

Taxes on benefits begin for single taxpayers with $25,000 or more in combined income, and for married taxpayers with $32,000 or more in combined income. Initially, only 50% of benefits are taxable. But if your combined income rises above $34,000 for singles and $44,000 for married couples, up to 85% of benefits are taxable.

Got all that? Yet even this isn’t a complete list of income classifications, especially for those with complex financial situations. Indeed, there are nuances and subtleties to many of these items. You know the phrase “buyer beware”? The same applies to taxpayers.

Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. He enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter @RConnor609 and check out his earlier articles.

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