24—Lever #2: Taxes (Part Two—Your Taxable Income)
You may already know this, but you don’t pay taxes on all the money you earn. You pay it on what is called your “taxable income.”
All federal income tax calculations are based on taxable income. The lower your taxable income, the lower your taxes. (Some people have zero taxable income.) Taxable income is different from your “gross income” (a.k.a. your “take home pay”), and it’s also not your “adjusted gross income” (if you’re not familiar with that term, you will be after reading this article).
Taxable income is pretty easily computed, and I’ll show you the basic equation later in this article. Of course, many tools will do that for you and tell you how much tax you owe, and most of you will go that route and use one of them, which is perfectly fine. (I’ve listed some in the resources section at the end of the article.)
Still, I want to walk you through the calculation manually so that you understand how the tax system works, especially the things that lower your taxable income. Working through this and calculating your taxes owed (which we'll cover in the following article) is a great way to better understand the tax code's basics. The more you know, the more you can minimize your taxes.
First, we need to discuss some key terms and tax accounting concepts. There are “above the line” adjustments to your gross income that are used to calculate your “adjusted gross income” (AGI). These adjustments are taxable income regardless of whether you itemize or take the standard deduction.
“Below the line” deductions are itemized deductions subtracted from AGI to determine your taxable income. However, for 2025, they are only helpful if their total exceeds the standard deduction of $15,000 for single filers and $30,000 for married filing jointly.
Your eligibility and limitations for these deductions may vary. Above-the-line deductions, such as student loan interest, often have specific income thresholds, while below-the-line deductions, like state and local tax deductions, may be capped or phased out.
Your adjusted gross income (AGI) is a key calculation because it determines eligibility for various credits and deductions, such as the Earned Income Credit or Child Tax Credit. It also determines the phase-out ranges for certain deductions and credits and affects eligibility for Roth IRA contributions, which are phased out at higher AGI levels.
Here’s a simple way to think about it:
Okay, with that accounting lesson out of the way, we’ll start with your gross income, which is a simple addition problem. Let's assume that your salary is $60,000 for illustrative purposes. If your only income is a salary, you're done; otherwise:
Next, you must calculate your adjusted gross income (AGI), your gross income (from above) minus specific “above the line” adjustments:
Technically, HSA and Traditional 401(k) contributions lower your AGI before you make any other above-the-line adjustments. That’s because your employer deducts them directly from your paycheck.
HSA contributions can also be made independently (not through payroll deductions). In that case, you can deduct them as an adjustment to your AGI when filing your taxes.
We have your AGI number ($50,900), but we're not through yet, even though your taxable income has already been reduced by 15%. We can now calculate your taxable income using a simple formula, which is your AGI minus your standard deduction or itemized deductions (“below the line deductions”), whichever is greater, shown as the Max() function in the simple formula below:
Adjusted Gross Income (AGI) – Max(Standard Deduction,Itemized Deductions) = Taxable income
Here are the standard deduction amounts for 2025 based on filing status:
Single Filers: $15,000
Married Filing Jointly: $30,000
Heads of Household: $22,500
As most of you will take the standard deduction, I won’t do a “what if” scenario for the itemized deductions. Suffice it to say that unless your itemized deductions exceed $15,000, the standard deduction will be optimal ($30,000 if you are married and file a joint return). However, just so you are aware of what they are, here is a list of the major itemized deductions taxpayers can take:
Medical and dental expenses (only the portion exceeding 7.5% of AGI)
State and local taxes—"SALT” (capped at $10,000 for state income and local property taxes)
Mortgage interest (on loans up to $750,000 for homes purchased after 2017)
Charitable contributions (up to 60% of AGI for cash contributions to qualifying organizations)
Casualty and theft losses (only for federally declared disasters)
Gambling losses (limited to gambling winnings—how weird is that!)
If you think your itemized deductions could be greater than your standard deductions, you can combine all your records and total them up. But they probably won't be unless you have significant charitable contributions, mortgage interest, health care expenses, or own a business. (The higher your income, the more likely that could be.)
That said, I’m going to use the standard deduction. So, to calculate your taxable income without itemizing, you subtract $15,000 ($30,000 if you're married) from your AGI:
$50,900 – $15,000 = $35,900
About 90% of all taxpayers take the standard deduction. The other 10% itemize deductions when their total deductions exceed the standard deduction.
We’ve got your “taxable income,” so that does it for now, but I want you to think about the effect that using various tax-advantaged benefits and retirement accounts had on your taxable income. You started with $60,100 in gross income and ended up with only 60% being taxable.
This reduction in taxable income positively impacts the “Sum of all taxes” part of the Financial Life Equation by lowering our yearly taxes. (Remember that Future wealth = Starting wealth + Sum of all income – Sum of all taxes (∑Tt+i) – Sum of all giving – Sum of all living expenses + Sum of interest earned – Sum of interest paid.)
That’s why I initially said you don’t pay taxes on everything you earn.
In the following article, we'll calculate exactly how much that tax will be, and I think you may be surprised (at least a little). We'll also discuss tax brackets and marginal tax rates along the way. Later, we’ll discuss how to decide how much in taxes to withhold from your paycheck to keep the IRA at bay while not giving them free use of your hard-earned money.
For reflection: We’ve seen how the IRS allows us to reduce our taxable income, sometimes considerably as a percentage of our total income. Still, most of us will owe some taxes. Can you cheerfully and with gratitude pay what you owe? Perhaps not so much as you resent or even have contempt for the IRS or how the government spends our tax dollars. Governments have been established to bring order, but sometimes, they conflict with personal convictions or even God’s commands. What should our first biblical response be? See the verse below.
Verse: “First of all, then, I urge that supplications, prayers, intercessions, and thanksgivings be made for all people, for kings and all who are in high positions, that we may lead a peaceful and quiet life, godly and dignified in every way” (1 Timothy 2:1-2, ESV).
Resources:
IRS: Deductions and Credits for Individuals
IRS Income Tax Estimator (Turbotax)
Income Tax Calculator (IRS eFile)