The Anatomy Of A Tax Return
It’s that time of year….raise your hand if you like doing your taxes!
OK, so I know that tax season can be very stressful for everyone. You have to be somewhat organized and get all sorts of forms and papers ready so that your CPA (or you, if you’re so inclined) can figure out if you’re going to get a tax refund or owe taxes.
Our country’s tax system is really complicated. That’s why we have whole industries that are dedicated to taxes: how to compute them, how to enforce them, how to work around them (legally, of course!). As much as most people dislike this annual chore, I think that taking a closer look at your tax returns can actually be, dare I say, enlightening?
Here’s a quick history lesson: In 1862, President Abraham Lincoln was the first president to sign a law that required the payment of income tax due to the costly Civil War. This was repealed 10 years later. Fast forward to 1913, and the 16th Amendment was ratified, which gave Congress the power to collect income taxes. This was also the year that the 1040 form was introduced. Since then, this country has seen quite the number of laws that have determined how much each individual or household must pay in taxes.
So here’s a little primer about your federal tax return. I’ll be keeping this relatively brief as there are entire books and blogs dedicated to digging deeper into understanding this topic. The purpose is to get a general overview of how your tax return is organized and how your taxes are calculated. The numbers and figures below pertain to tax year 2017.
I will introduce Dr. Barkley so that the numbers will make a bit more sense. Dr. Barkley is a 30 year old small animal practitioner who is single.
FORM 1040- U.S. Individual Income Tax Return
So let’s start with Form 1040. It’s only 2 pages long, but it is chock full of information. This form is the ultimate summary of last year’s income and taxes.
Filing status: There are 5 categories: single, married filing jointly (MFJ), married filing separately (MFS), head of household, and qualifying widow/widower with dependent child. Each filing status has specific qualifications, and you have to run the numbers to see whether one filing status makes more tax sense than another. For example, generally speaking, it’s more tax favorable to file jointly if you are married. However, if one spouse has significant deductions, or combining their incomes will push them into a higher tax bracket, they may consider filing separately.
In Dr. B’s case, she checks off the “single” box for filing status.
Exemptions: You claim a personal exemption for yourself if you are single, as long as you are not considered a dependent. Other exemptions typically include your spouse, children and/or dependent adults.
In Dr. B’s case, she would claim a personal exemption for herself.
FIRST, LET’S FIGURE OUT INCOME
Income: This is the combination of all the different ways you can earn income. If you earn income through an employer, you get a W-2 form. You can earn income through a business. Alimony is considered income. You can make passive income, such as dividends from investments or rental property. Line 22 is your total income.
Dr. B’s income was calculated to be $100,000.
Adjusted gross income: Now we’re making income a tad more complicated. There are certain items that can be subtracted from Line 22 which are considered credits. Popular credits include a health savings account, qualified retirement plan contributions, and student loan deductions. These credits are awesome because they will, dollar for dollar, decrease the amount of tax that you will owe. We end up with line 37, which is your adjusted gross income (AGI). This is an important number as it will determine if you’re eligible for certain tax credits and exemptions.
Your modified adjusted gross income (MAGI) adds back certain deductions, like student loan interest and higher education expenses. Again, this number will determine eligibility for certain tax credits and exemptions. Usually, AGI and MAGI are pretty close, if not identical.
So how can MAGI affect your tax situation? Let’s take your student loan interest as an example. You can deduct up to $2,500 of student loan interest for the year. If your MAGI exceeds $80,000 as a single taxpayer, then you are no longer eligible to take this deduction.
For simplicity’s sake, Dr. B’s AGI and MAGI are identical at $100,000. In this case, since she makes more than $80,000, she will NOT be able to take the student loan interest deduction.
Taxes and Credits: This section will take into account your deductions. This can be the standard deduction, which for tax year 2017 was $6,350 for those filing single.
The recent Tax Cuts and Jobs Act made a significant change in this department. Beginning with tax year 2018, the standard deduction will be $12,000 for those filing as single.
There is also the option to itemize your deductions. You will want to do this if itemizing your deductions will give you a larger number than the standard deduction. Calculate your deductions both ways and use the method that will give you the larger deduction.
In Dr. B’s case, it makes most sense for her to take the standard deduction since itemizing her deductions would not result in a larger number.
You will then end up with your taxable income (line 43). This is the number that will determine which tax bracket you are in.
In Dr. B’s case, her taxable income is:
$100,000 (adjusted gross income)- $6,350 (standard deduction for single filing status) – $4,050 (personal exemption) = $89,600.
Now is the point where tax brackets come into play.
2017 tax brackets for filing status single:
10%: $0-$9,325
15%: $9,325-$37,950
25%: $37,950-$91,900
28%: $91,900-$191,650
33%: $191,650-$416,700
35%: $416,700-$418,400
39.6%: $418,400+
This is called a progressive tax system, which means that those with a higher income will be taxed at a higher rate.
Looking at the tax brackets for 2017, she is in the 25% tax bracket because her taxable income is $89,600. Remember, we don’t use gross income for determining your tax bracket.
Important note: This does NOT mean that all $89,600 will be taxed at 25%. The first $9,325 is taxed at 10%. Then the income from $9,325-$37,950 is taxed at 15%. Then the income from $37,950-$89,600 is taxed at 25%.
HOW MUCH TAX?
Lines 44-63 focus on computing your taxes. Line 63 is your total calculated tax. This is the amount that you actually owe in taxes. However, you’ve been paying taxes the entire time, usually out of your paycheck or through quarterly payments. What you have already paid is line 74.
In Dr. B’s case, she had paid $20,000 in taxes over the year (line 74). Her calculated tax is $18,138.75 (line 63).
Now we’re getting to the part that serves the whole purpose of this exercise- how much you will either owe in taxes, or how much you will be getting back as a tax refund. You subtract line 63 (your total tax) from line 74 (taxes you have already paid). If your number is positive, then congratulations, you get a refund! If your number is negative, then sad face….you will owe taxes. Hopefully it’s not too much.
Here is the calculation for Dr. B:
$20,000- $18,138.75= $1,861.25
Final Verdict: Dr. B. gets a tax refund of $1,861.25 from the federal government this year!
EFFECTIVE TAX RATE VERSUS MARGINAL TAX RATE
As mentioned earlier, your tax bracket does not mean that your entire income is taxed at that rate. Your effective tax rate is a better measure of how much of your income went to taxes. The calculation is your total tax divided by your gross income.
For Dr. B, her effective tax rate is:
18,138.75/100,000= 18.1%
The marginal tax rate is the rate that your next taxable dollar will be taxed. This is your tax bracket rate, which means that if Dr. B were to earn one more dollar, she would keep 75 cents of it and 25 cents goes to taxes.
THE TRUTH ABOUT TAX REFUNDS
Now, if you got a refund, don’t get too excited. It’s nice getting to deposit that check, but you must realize that theoretically, this was your money all along. You had actually been OVERPAYING your taxes all year. The amount on that check could have been in your hands the previous year, and you would have been free to use it however you’d like. In fact, if you had invested it, you could have very well made money off of that amount. In essence, you let the government borrow money from you, interest free might I add.
Ideally, you would have a balance of zero where you would get no refund and owe no taxes. If you want to get your number closer to zero, you can adjust your W-4, which is your tax withholding form that is given to your employer. This form tells your employer how much you want taken out of your paycheck for federal taxes. It is recommended to update this form whenever your financial situation has changed, such as getting married or having children.
SCHEDULES
The other sections after the 1040 are supporting documents to the 1040.
Schedule A: These list all of your itemized deductions if you chose to go that route over the standard deduction. This includes items such as state and local taxes, mortgage interest, and charitable giving.
Schedule B: Interest and Ordinary Dividends
Your checking and savings accounts will produce some interest income. This is your financial institution’s way of thanking you for keeping your money with them.
If you have an investment account, you will receive an ordinary dividend if the companies in your account are profitable and decide to share the good fortune with their shareholders.
Schedule C: Net Profit from Business
If you’re a business owner or entrepreneur, you get your very own schedule. This obviously adds to the level of complexity to your tax return.
Schedule D: Capital Gains and Losses
Say you have an investment account, which may include individual stocks or mutual funds. If you happen to sell a stock, then whatever money you gain or lose compared to what you bought it for initially is considered your capital gain (or loss).
This section also includes any money that you converted to a Roth IRA, or if you took a distribution from a Roth IRA.
Schedule E: Income (or losses) from rental real estate, royalties, partnerships, trusts, estates, etc.
A more detailed look at different ways you could have earned income.
There are additional schedules, as well as countless forms and worksheets that serve as supporting documents for the tax return.
STATE RETURNS
Whew! Wasn’t that fun? And that was just your federal tax return! How about your state tax return?
Luckily, this tends to be much easier to fill out. It still requires your federal adjusted gross income (line 37 from 1040) and will use other computations from your federal return. Each state has its own set of rules for deductions and adjustments.
If you have moved, or if you live in one state and work in another, then you will need to fill out multiple state returns.
FINAL NOTE
Once I started doing tax returns via Turbo Tax, I actually started looking forward to doing our taxes. Strange, I know. But it became a bit of a game to see how we could maximize our credits and deductions. It has also been interesting to see the change to our taxes as our family situation and income has evolved over the years.
Hopefully you’ve learned a little something about taxes. Most likely, this just solidified the fact that taxes can be horribly complicated. What makes them more complicated is that the rules are changing all of the time, as evidenced by the recent change in law. Who knows what sort of system we will see in the future, but it’s always important to at least have a sense of what is in your tax return. Once you understand how you are taxed, you can perhaps make some changes that will turn the numbers in your favor.
There has already been a lot of press around the new Tax Cuts and Jobs Act. This will intensify when we enter the next tax season. In the meantime, if you felt overwhelmed by this year’s taxes, don’t repeat the cycle by procrastinating. Dedicate at least 1 file folder for all of your tax related items, and keep your previous year’s tax return handy so that you can refer to it when the time comes. Lastly, educate yourself and keep in contact with your tax preparer throughout the year so that you will be better prepared next year.