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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:
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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The IRS uses the term “adjusted gross income” on the 1040 but not simply “gross income”. Instead, they use “total income”. One additional thing that it doesn’t include is contributions to traditional IRAs, 401(k)s, and 403(b)s, which aren’t included in your wages on the W-2.
FYI Alimony is not deductible for divorce decrees after 2018.
Bill W.
I think you referenced this in one of the paragraphs, but I was painfully reminded about it yesterday while doing our 2022 tax return on TurboTax. It is called ‘earned income’.
My wife and I were never able to get a deduction for contributions to our IRA while we were working because we made too much money. We are now retired and only receiving income from pensions, so we have zero ‘earned income’, even though we pay taxes on the pensions. I decided last year to contribute $7000 to my Roth IRA from my taxable brokerage account.
Not so fast – this is not allowed because we have no earned income. Now I have to reverse out the contribution to avoid a 6% IRS penalty that would go on for perpetuity. Ugh.
Thanks Rick. A good and timely topic.
Having previously been a CPA in public practice that focused on preparing individual returns. I would suggest the following when working with a tax preparer –
Complete your tax organizer particularly the questions. If you are unsure of the answer put a “?” on the response and discuss the organizer items with your preparer on the front end. Typically a “yes” response by you means a matter to discuss. No organizer? Ask for one.Gather all tax documents and send / deliver at one time if possible. Many preparers prefer copies vs. original – ask your preparer. If you are sending the preparer paper copies of the documents let them know if the documents do not have to be returned. If your firm uses a secure electronic portal use it to save the preparer time and you money. Most firms now keep all documents in electronic format. You keeping the original, or copies, before sending means the data can be replaced easily if lost in mail, file is corrupted or your preparer drops over in the middle of tax season.There are thieves that want your personal tax data to rob you and/or the government. Do not help them steal your data by sending sensitive tax data in an email or attachment.Let your preparer know about your expectations of the next year estimated income and expected income and life changes (Job change, retirement, illness, marital status, children, college, etc.). The typical SALY default assumption in tax planning for next year, same as last year, may not be to your benefit.Ask what you can do for the current year and future years to make your return filing work easier for both of you and ask your preparer of any ideas on actions you can consider or take to save taxes and time. Ask every year.If you know you are going to be waiting on a K-1 or other documents to file your return in April go ahead and direct your preparer to get the extension now and do the work after April. Most high end tax software programs have a projection feature and if you are using the same preparer as the previous year this tool can be a very efficient way of getting a good guess on your current year tax obligation and actions you may need to take. No one likes being told they need to make a big tax payment tomorrow.If your return is being prepared at a larger firm it may be (think likely) that the person preparing your return is not the person signing it. Tell your preparer you are happy to hear directly from the persons who are doing the hands on work if they have data needs or other questions. Doing so is usually more efficient and may reduce rework time that you are paying for. Partner billing rates are higher than staff.Planning complex tax strategies is usually best on a team basis. Get open communications established between your preparer, financial planner, insurance agent, banker, attorney, etc. as appropriate. If married, having both spouses involved in tax planning usually works best, particularity in the fourth quarter of life. If the future strategies planned events will occur when you or your spouse will no longer be involved evaluate the need and benefit of getting your adult kids (or other beneficiaries) involved now.Check annually that your primary and contingent beneficiaries are as you intend and your will and estate documents are current. If not update them.Best, Bill
Bill,
Thanks very much for a thorough review of the taxpayer / preparer relationship. I’ve experienced a portion of this while volunteering as a VITA tax preparer. The IRS provides an intake form that is available to anyone if they do their own taxes, or want to help organize their data. It is geared toward individuals and / or simple self employment. The demographic questions aren’t germane to an individual, but the rest of the data is helpful.
Best,
Rick
https://www.irs.gov/pub/irs-pdf/f13614c.pdf
As stated in another comment, I no longer do my own taxes either, even though I enjoy finances and investing. It’s just too big a bucket of worms and is worth the fees our professional tax preparer charges along with the chance to as a few questions face to face.
I no longer do my own taxes for the reasons this great article points out. Rick, you bring out many of the “don’t know what I don’t know” issues.
I have to ask my tax person all the dumb questions that the IRS triggers in my simple mind.
There are no dumb tax questions.
I asked this “dumb” question to a friend who did their own taxes for years. Here is what I asked:
A couple in 2023 will be filing taxes as MFJ, both age 65, retired, no pension and no SS yet. They are surviving by periodically taking long-term capital gains totaling $89,250.00 for the year from a taxable investment account.
Do they owe any federal tax? The person I asked thought for sure they would. Thoughts from anyone?
Well, the 2023 capital gains bracket for MFJ is a 0% capital tax rate is up to $89,250 so assuming congress does not enact a retroactive tax change effective in 2023 and the LT gain is not from the sale a collectible (think gold), that is taxed at a different rate, the answer is zero assuming the facts you presented. They would be required to file a return even though no tax is due. Even as simple as their return would be I would still recommend filing electronically to avoid a potential input error by the IRS or a mismatch with third party reporting document (1099-B). If the basis of the asset sold was from a non-covered asset then the basis of the asset would not have been reported the IRS.
In 2022 the free file maximum AGI limit to be eligible for one of the free file vendor programs is $72K and I guess the 2023 eligible limit would be approximately the same + inflation. These MFJ taxpayers would be eligible for the unlimited income IRS Free File Fillable Forms program where they could electronically file, but that program can challenge anyone without the tax knowledge and skill. Thus they would likely be stuck paying for zero tax return to be electronically filed.
I suggest the US adopt a tax system similar to New Zealand’s where most all income gets reported to the government (as most is already done in the US to the IRS) and the government sends a completed return to the taxpayer and the taxpayer signs if no change or then the taxpayer would provide additional information to the IRS (as they already do in the current system) if the taxpayers have other income and/or deductions. The US tax code would have to be simplified for the change to work, just as New Zealand tax law had to do. I think this type of change would free up resources so the IRS could focus on the crooks who are cheating the system. I am not holding my breath.
Alternatively, the US code’s complexity appears to be the major stumbling block that keeps the IRS from even developing a free individual program that actually functions and could be used by high income taxpayers with low complexity returns. This type of change would be opposed by the tax preparation industry.
My pet peeve-extensions. Wasted time and effort for all. Just have a due date of 10/15 every year. No impact on the vast majority of taxpayers who are overpaid or that pay a good faith balance due by 4/15 of the following year. The government could bill for interest and penalty from 4/15 to 10/15 if underpaid. The government is typically not getting that money anyway until the return is filed.
I retired from public accounting but still have my own return to do. I am working to make it simple.
William, thanks for your explanation! I used the $89,250 example because that is what the IRS is showing as the top LT capital gains allowed for the 0% federal tax for 2023 and filing MFJ.
You do point out some factors that could cause a glitch and tax might be owed. I wanted to play out this scenario on a tax module, but since I don’t do my own taxes, I thought it might too cumbersome to input figures to get a result.
Your professional opinion is very much appreciated. I’ll have to save your response so I can refer back to it easily. Thank you!
You can google AARP free tax calculator for a good what if tax calculator but it is currently for tax year 2022. I do not know when they switch over to 2023. The 2022 calculator would likely get you a conservative ball park amount but would not include the inflation changes to the 2023 brackets and would likely overstate the 2023 tax by a small amount if you use your 2023 estimated data. That is what I do.
Thanks! I’ll see if I can work through it.
Thank you for this, Rick. The tax code’s complexities are insane, and the different ways MAGI is defined is a prime example.
If anyone ever manages to simplify it, they should get a Nobel Prize.
I have heard suggustions that all members of congress should have to prepare their own 1040 without a computer program is how the code could be simplified.
How about a multi-tier flat tax and a VAT and scrap the rest? Nah, too simple. No fun without lobbyists.
There is also the FairTax (FairTax.org). It would eliminate so many problems for taxpayers. This one is also simple but as you point out not good for the lobbyists and so many others.
FairTax – what an Orwellian name. 30% tax on everything a working stiff buys.
Meanwhile the Billionaires will laugh all the way to the bank as the yachts, private jets, multi-millionaire $ jewelry, ect., ect., ect. that they buy overseas gets taxed 0%.
It’s a “FairTax” if your goal is to redistribute even more money to the already wealthy and stomp on the face of everyone else.
$30 65 or older each person get an extra $1500 for their standard deduction, so that a married couple has a standard deduction of $30,000.
No mention of qualified dividends? The zero percent bracket for these dividends is a fabulous gift to retirees, particularly married couples.
Suppose you were collecting $40K in total SS and $100K in qualified dividends. With the standard deduction, you’d have only $6300 in ordinary income taxed at 10%. Of your $100K in stock dividends, about $83K would be taxed at 0%, and you’d pay 15% on the rest. Your total Federal tax would be about $3200, and you wouldn’t have to pay IRMAA.