If you look on the second page of your 1040, you’ll see on the top left-hand side a box that says “Standard Deduction.” If you’re single (aka not married), your standard deduction is $6,100 for 2013. What is a deduction? It’s basically just another item that reduces the amount of income you have to pay taxes on. It’s taken after you calculate your Adjusted Gross Income (Line 37/38). You can take either the standard deduction or an itemized deduction on your tax return, but not both.
Most of us will be taking the standard deduction because the total of our itemized deductions won’t be greater (i.e. won’t be above $6,100 if you’re single in 2013). Since deductions reduce your taxes, you always want to take the deduction that has the largest amount between the two.
- medical & dental expenses that add up to being more than 10% of your AGI
- certain taxes
- home mortgage points
- interest expense
- charitable contributions*
- casualty losses/theft
- miscellaneous itemized deductions (above 2% of your AGI)
- miscellaneous itemized deductions (with no 2% AGI limit)
*A lot of people donate to church or a charity thinking it will reduce their taxes. Unfortunately, unless your donation plus anything else on the itemized list is more than the standard deduction, you won’t receive any tax benefit from that donation. You should still donate, of course. I just want to clarify the popular misconception.
To get our Adjusted Gross Income (Line 37 of our 1040), we get to subtract certain expenses from our Gross Income (Line 22 of our 1040). The expenses we get to deduct is often referred to as items “deducted FOR AGI” or “ABOVE the line deductions”.
Here is what you can subtract (I suggest looking at a 1040 as you read this list! The items in green are more common to us millennials.):
- Line 23) educator expenses up to $250 (applies if you’re a teacher who paid for classroom supplies out of your own pocket)
- Line 24) certain business expenses (this is only for a very select group of people)
- Line 25) HSA contributions (money you put into your Health Savings Account if you have one)
- Line 26) moving expenses (you have to be moving for a new job and it has to be a qualified expense)
- Line 27) half of your self-employment tax if you’re self-employed
- Line 28) contributions to a SEP, SIMPLE or qualified plan (applies only if you’re self-employed)
- Line 29) self-employed health insurance deduction
- Line 30) early withdrawal penalties (like when you get charged for taking money out of a CD before the maturity date)
- Line 31) alimony paid (won’t apply unless you’re divorced)
- Line 32) money you put into your Traditional IRA up to $5,500 in 2013 (your salary has to be within the limits)
- Line 33) money you used to pay for the interest on your student loans up to $2,500. This is part of the reason why student loans are considered “good debt.”
- Line 34) tuition & fees up to $4,000 in 2013.
- Line 35) domestic production activities
You add all those items up and put the total on Line 36 and then subtract Line 36 from Line 22 (your Gross Income). The difference goes on Line 37, which is your AGI.
Your AGI is used for a number of tax calculations. So the lower your AGI, the better.
I am not yet qualified to be recommending specific stocks or mutual funds for you to invest in. But J.D. Roth from Get Rich Slowly surely is. In his post The Sheep and the Wolves: Smart investing made simple, Roth does a great job illustrating the basic concepts of investing along with providing some specific fund recommendations. So if you already have a retirement and/or taxable account set up but you’re at a loss as to what to invest in, why not start with his picks? He backs his suggestions up with some pretty sound facts.
Here is a list of what’s NOT included in your gross income (line 22 of your tax return). These are the best types of income to receive because you don’t have to pay taxes on it!:
- gifts (like money you receive for your wedding gift, your birthday, Chinese New Year, etc.)
- non-cash fringe benefits (these are perks you get at work like free donuts, free coffee, etc.)
- return of basis (this is the original amount you put into your investments)
- employer contributions to certain health insurance plans (i.e. HSA, MSA, or cafeteria plan)
- when your employer pays for the premiums of your group term life insurance (up to a death benefit of $50,000)
- workers compensation (income you receive from getting injured at work)
- child support
- benefits received under your health plan
- educator assistance up to $5,250 (when your employer pays for your education, you don’t have to pay taxes on the first $5,250)
- death benefit of life insurance
- personal injury damages
- scholarships & fellowships
- employer provided dependent care up to $5,000
- employer contribution to a qualified retirement plan (like when your employer matches your 401k)
- Roth IRA distributions (because you used after-tax dollars to fund this account)
Click here for a list of income you DO have to pay taxes on.
Gross income (also known as Total Income) is the number that’s going to be on Line 22 of your 1040 tax return.
I suggest looking at a 1040 while I explain line by line what your gross income will include. The items in green apply to most of us millennials.
- Line 7) wages, salaries, tips, etc. (your employer(s) will send you a W-2 with all this information)
- Line 8) taxable interest (this includes stuff like the .01% interest that you get from your savings account!)
- Line 9) dividends (won’t really apply unless you have investments)
- Line 10) taxable refunds, credits, or offsets of state and local income taxes
- Line 11) alimony received (won’t really apply unless you’re divorced)
- Line 12) Schedule C net income or loss (won’t really apply unless you own your own business)
- Line 13) capital gain or loss (won’t really apply unless you have investments)
- Line 15 & 16) IRA distributions and pensions & annuities (won’t really apply unless you’re retired)
- Line 17) Schedule E income (won’t really apply unless you have income from a rental property, partnership, trust, etc.)
- Line 18) farm income or loss (won’t really apply unless you own an income producing farm)
- Line 19) unemployment compensation (won’t really apply unless you receive unemployment income from the government)
- Line 20) social security benefits (won’t really apply unless you’re retired or disabled and receiving income from our social security system)
- Line 21) other income (this is for all the other ways you might be getting income: winning the lotto, awards, 1099, gambling, jury duty, etc.)
Line 22 is all these items added together to make up your Total Income.
Next time I will cover what’s NOT included in your gross income. Also known as what ways can you receive money without having to pay taxes on it.
Asset allocation refers to the percentage of money you should put into each type of investment. The asset allocation for your retirement account should be different than the asset allocation for your investment account because the assumption is you will not be needing the money in your retirement account for a long time (30+ years) but you may or may not need the money in your investment account in the next few years.
For your investment account, you should have an asset allocation that reflects your risk tolerance. If you don’t know what your risk tolerance is, think about your gambling style. Do you tend to play it safe (low-risk tolerance)? Or are you a double or nothing kind of person (high-risk tolerance)? There are also tests you can take to help you get an idea. Even if you are a conservative investor, you should keep very little in cash/cash-equivalents unless you plan on making a big purchase soon. Your emergency fund should be enough to cover any unexpected cash needs.
For your retirement account, you should have all or almost all of your investments in equities regardless of your risk tolerance. This is assuming you’re a millennial and won’t be retiring soon. Even though you could lose a lot of money in the short run with equities, your portfolio has plenty of time to bounce back. And like I mentioned before, equities have unlimited potential for growth and will thus, protect you from inflation way better than bonds will. But the closer you get to retirement, the less you should have in equities and the more you should have in bonds.
The three main types of investments are equities, fixed-income and cash/cash-equivalents.
Stocks and mutual funds are two very popular examples of equities. They’re what we’re most familiar with when we think of “investing” or “the stock market” (Apple stock, Google stock, Facebook stock, etc.). When you invest in equities, your main goal is to make money through the growth of these stocks and/or mutual funds. Even though there is an unlimited amount of money you could potentially make investing in equities, the trade off is it’s a bit of a gamble. You could also lose most (or all) of your money too.
Fixed-income most often refer to bonds. Bonds are basically when a government or corporation pays you interest for letting them borrow your money. Bonds will give you a pretty predictable amount of income at regular intervals like 5% every 6 months. The steady stream of income you get from bonds makes it a “safer” investment than equities. But they will never grow like equities so don’t expect to get rich overnight from this type of investment.
Cash is pretty self-explanatory. Cash-equivalents refer to investments that can be easily converted into cash without losing value (like bank CDs and T-bills).
Now that you know what the 3 most common types of asset classes are, next time we’ll cover how much money you should invest in each group. The investment lingo for this is asset allocation.