What is income, anyway?
A reader sent me an email after my last post and asked me to clarify what I meant when I referred to income when figuring tax rates. That same day, another reader on twitter asked me to explain how our progressive income tax system works – did all income get taxed at one rate or is there something else? As I was replying, I realized that a lot of what is driving taxpayer confusion over tax policy is trying to sort out what folks are talking about. Income is a loaded word – it could mean so many things. Here’s a quick explanation of common tax terms and what they mean:
Gross Income. Gross income is your total income before taking any taxes paid or deductions into account. Most individual taxpayers think of gross income as what appears on form W-2 in box 1.
Total Income. It gets a bit confusing, however, because IRS also uses the term “Total Income” to describe more or less the same thing as gross income – though certain kinds of net income (like business income) are included in this figure after expenses. At its most simple, total income is the term that the IRS uses to describe all of your income – earned and unearned – before statutory adjustments, exemptions or personal deductions. You’ll see it on line 22 of your 1040:
Adjusted Gross Income (AGI). AGI is your total income less minus certain adjustments for items like moving expenses, student loan interest, IRA contributions and alimony. Those adjustments (found on lines 23 through 35) are often referred to as “above the line” deductions since they can be claimed whether or not your itemize. You’ll find AGI on line 37 of your 1040.
Taxable Income. Taxable income is AGI less your deductions (using the standard deduction or itemized deductions) and personal exemptions. Your taxable income is reported on line 43 of your 1040. This is the figure that is used to calculate your tax rate.
Tax Rate. Unless you’re in the very bottom tax rate, there is no single tax rate. Here’s why: we have a progressive tax system which means that all taxpayers pay the same tax rate on each level of income as opposed to a flat rate. If you look at the tax rate schedule, you can see this pretty clearly. For example, using Schedule X below, you’ll note that all single taxpayers, regardless of level of income, pay 10% on the first $8,500 of taxable income. Single taxpayers next pay 15% on taxable income between $8,501 to $34,500 (in addition to the 10% on the income up to $8,500, which is why you see “$850+” on the schedule) and so on.
Marginal Tax Rate. The marginal tax rate is what most taxpayers actually refer to as their tax rate but it’s not – not exactly. The marginal tax rate is actually the taxpayer’s top rate. It is the tax rate the taxpayer will pay on the next dollar of taxable income. Remember – it’s a progressive system so, referring to that tax table above, if a single taxpayer reports taxable income of $100,000, the marginal tax rate is 28% meaning that at dollar $100,001, the taxpayer will pay an additional 28 cents – and so on. The actual rate of tax paid on the entire $100,001 will be less than 28% – if you figure the tax using the chart, it is $21,617 or 21.6%.
Effective Tax Rate. There’s a lot of controversy about how best to define the effective tax rate for individual taxpayers (ironically, there’s a lot more consistency when it comes to defining effective tax rates for businesses). The effective tax rate is often described as the average tax rate paid – but the word “average” can be tricky. The average of what? The Tax Foundation uses taxable income for its calculations: total tax paid divided by taxable income (more or less how I calculated the 21.6% figure above). For purposes of my Romney article, I calculated the effective tax rate using the rate of total federal income tax owed vs. total income because that eliminated most adjustment issues. A more sophisticated formula – as was suggested by many of my tax pro colleagues – involves taking taxable income divided by the sum of income tax figured before credits (line 55); self-employment tax (SE tax at line 56) and FICA taxes paid (from your W-2) but then you’re starting to do some serious math and running into the “what about *insert random tax issue here* scenarios.” Using different formulas can result in variations on effective tax rates but for purposes of most discussions, so long as you compare apples to apples (meaning you use the same formula each time), you’ll get a decent sense of the average rate.
Total Tax. This is the amount of tax calculated under the tables in addition to SE tax; household employment taxes payable and other taxes due (like the repayment of the first time homebuyer credit). You can find it on line 61.
Tax Due. This is the line most taxpayers hate. It’s what’s still owed after you've calculated the tax due and taken into account all of the withholding, credits and payments (but not including estimated tax penalty). It’s the dreaded line 76.
So that’s a brief rundown of tax terms you might hear tossed about. I know that there is inevitably going to be a tax pro (or two or three) out there somewhere who is going to take issue with how I've explained at least one of the terms. That’s to be expected: there’s a lot of confusion and conflict even within the industry. It’s how our geeky minds work. Meanings are also contextual and they vary depending on what type of tax you’re talking about and who’s paying the tax (if you don’t believe me, take a look at the numerous glossaries on the IRS web site alone). If you have something to add to clarify a term, please, by all means, please leave a comment – but if you just want to complain at me generally or cite Regs and case law, do me a favor and just send me an email. 
And for the record, line numbers in this piece refer to the form 1040 for 2011 (downloads as a pdf).
Article originally published on Forbes by Kelly Phillips Erb
Security Tax Services LLC
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