For tax purposes, "gross income" is all the money a person receives in a given year from any source. But income taxes are levied on "taxable income" rather than gross income. The difference between the two is the result of many exemptions and deductions. To see how they work, suppose you made $50,000 last year in wages, $10,000 from investments, and were given $5,000 as a gift by your grandmother. Also assume that you are a single parent with one small child living with you.

a. What is your gross income? 

b. Gifts of up to $12000 per year from any person are not counted as taxable income. Also, the "personal exemption" allows you to reduce your taxable income by $3650 for each member of your household. Given these exemptions, what is your taxable income?

c. Next, assume you paid $700 in interest on your student loans last year, put $2,000 into a health savings account (HSA), and deposited $5,000 into an individual retirement account (IRA). These expenditures are all tax exempt, meaning that any money spent on them reduces taxable income dollar-for-dollar. Knowing that fact, what is now your taxable income?

d. Next, you can either take the so-called standard deduction or apply for itemized deductions (which involve a lot of tedious paperwork). You opt for the standard deduction that allows you as head of your household to exempt another $8,500 from your taxable income. Taking that into account, what is your taxable income? 

e. Apply the tax rates shown in the table below to your taxable income. Federal Personal Income Tax Rates, 2010* (1) (2) (3) (4) Total Marginal Total Tax on Highest Income Average Tax Rate Taxable Tax in Bracket on Highest Income Income Rate, % in Bracket,% (3) / (1) $1-$16,750 10 $1675 10 $16,751-$68,000 15 9363 14 $68,001-$137,300 25 26,688 19 $137,300-$209,250 28 46,834 22 $209,251-373,650 33 101,086 27 Over $373,650 35 *For a married couple filling a joint return How much Federal tax will you owe?

What is the marginal tax rate that applies to your last dollar of taxable income?

f. As the parent of a dependent child, you qualify for the government's $1000 per-child "tax credit." Like all tax credits, this $1000 credit "pays" for $1000 of whatever amount of tax you owe. Given this credit, how much money will you actually have to pay in taxes?

Using that actual amount, what is your average tax rate relative to your taxable income?

What about your average tax rate relative to your gross income?