Standard Deduction vs. Itemized Deductions

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.

Itemized deductions are also known as Schedule A and “deductions FROM AGI”.  Here are some examples of itemized deductions:

*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.

Adjusted Gross Income

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.):

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.

Investment Recommendations

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.

What’s NOT Included in Your Gross Income

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.)
  • inheritance
  • 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.

What’s Included in Your Gross Income

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.