The tax code is full of obscure terms like "adjusted gross income" and "capital gains" that, while difficult to follow, can have a big impact on how much of your income goes over to your favorite Uncle. For example, your AGI affects how much you can take for other deductions, like unreimbursed employee expenses and charitable contributions, while your capital gains might be taxed at different rates than the rest of your income.
Adjusted Gross Income
Your adjusted gross income equals all your taxable income minus all your adjustments to income, also called above-the-line deductions. Taxable income includes, among other things, your wages, salaries, bonuses, taxable Social Security, capital gains, unemployment benefits, alimony received and taxable retirement plan distributions. Adjustments to income include deductible traditional IRA contributions, student loan interest, moving expenses and alimony paid. For example, say you have $50,000 of wages, $6,000 of capital gains and $2,000 of taxable interest income, but you paid $1,000 in student loan interest and contributed $4,000 to your traditional IRA. Your AGI equals $53,000.
AGI isn't the be-all, end-all of your tax return because there's still more deductions to be taken. AGI doesn't include any personal exemptions claimed for yourself, your spouse and your dependents. It also doesn't include either your standard deduction or your itemized deductions, such mortgage interest, charitable donations and deductible taxes. For example, in 2013, each personal exemption is worth $3,900 and the standard deduction is $6,100 if you're single, so even if you're not itemizing, your taxable income is $10,000 lower than your adjusted gross income.
Capital Gains Calculation
When you sell property -- like stocks or your house -- any gain on the sale counts as taxable income. You figure your capital gains by subtracting your cost basis for the asset from the proceeds from the sale. For example, if your basis is $500 and you receive $600 from the sale, you have a $100 capital gain. Usually, your basis is what you paid to buy the item. For example, if you had to pay $500 to buy shares of stock, that's your basis. If you received the property as a gift, you get the same basis as the person who gave it to you. If you inherit it, your basis is the fair market value on the day the person died. Certain expenses, for example, major improvements to your house, can be added to increase the size of your cost basis.
Long-term Versus Short-term Gains
Though your taxable gain is calculated the same way regardless of how long you held the stock, your resulting tax bill varies greatly. If you only owned the asset for a year or less, it counts as short-term capital gains, which are taxed at the same rates as ordinary income. Long-term gains result from selling stuff you've owned for more than one year and are taxed at lower rates. For example, as of 2013, the maximum rate on short-term gains -- and ordinary income -- is 39.6 percent. But, long-term gains aren't taxed any higher than 20 percent.
- Internal Revenue Service: Definition of Adjusted Gross Income
- Internal Revenue Service: Form 1040
- Internal Revenue Service: Topic 409 -- Capital Gains and Losses
- Internal Revenue Service: Publication 550 -- Investment Income and Expenses
- Internal Revenue Service: Annual Inflation Adjustments for 2013
- Legal Information Institute: 26 USC 1
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