Understanding Taxes: Anatomy of a Tax Return
This time of year brings the midwinter blues — and with it, for many people, a bout of tax phobia. There can be a certain dread of not knowing — even negatively anticipating — the outcome of your soon-to-be-completed federal income tax return. In reality, the outcome of your tax return is already set. The missing ingredient is merely your knowledge of that outcome. And in financial matters, knowledge is a powerful antidote to fear.
Before April 15, you must file a return based upon last year’s data. (Unless, of course, you already have.)
Are you one of the multitudes who dread even the thought of navigating your own tax return? Fear not! For here we provide you with a simple explanation of how taxes work: the anatomy of a tax return.
Understanding Taxes: The Different Kinds of Returns
There are three versions of federal returns for personal income taxes: Form 1040EZ, Form 1040A, and Form 1040. They are all acceptable, with the 1040EZ being appropriate for the simplest of situations, the 1040A for slightly more complex situations, and the 1040 for the most complicated situations.
The 1040EZ can’t be used by individuals or couples claiming dependents or for taxable incomes of over $100,000. Plus, it can only be used with a filing status of single or married filing jointly. You can’t use this form and claim any type of deductions. There are other restrictions, as well, but suffice to say that this return is for the most basic of situations.
The 1040A is the next step up in complexity. You can claim dependents, and you can claim deductions, but you can’t use this form if you wish to itemize those deductions. You also still have the $100,000 taxable income limit. The 1040A can still be used in many basic situations.
The 1040 is the standard federal income tax return. You can always use it, no matter how complex your situation.
The danger of using too simple a form is that you may miss being able to take advantage of things like deductions and credits, which could further reduce your tax liability. The downside of selecting a more complex form than needed is that you will do more work to get the same exact result.
For those who use tax software programs, the programs select the appropriate form based on your situation — one less thing for you to think about. But even if you use a tax package, you’ll benefit from understanding where the whole thing is headed — how your tax return comes together. Let’s take it from the top.
How Do Tax Returns Work? The Step-by-Step Process
This is the essence of where you start. All three versions of the 1040 begin with your personal information. A joint return will require your spouse’s information, as well. You have to provide your name, address, and Social Security number.
For forms 1040 and 1040A, you have to indicate your filing status. If you aren’t married, you’ll file as an individual (single). If you are married, you can either file together as a couple (married filing jointly) or each file on your own (married filing separately). The latter generally isn’t favorable, but can be appropriate in some rare situations. There are two other filing options, as well: head of household and qualifying widow(er).
The “head of household” status is for unmarried people who provide a home for someone else, generally a child. An unmarried status can refer to people who are legally separated or living apart (among others), and the person for whom you’re providing a home doesn’t necessarily have to be your own child. The rules are detailed and specific, so if you think you qualify, read page 14 of the instructions for Form 1040.
The status of “qualifying widow(er)” is for widows and widowers whose spouses died in 2015 or 2016, who have remained unmarried through the end of 2017, and who have provided a home for a dependent child in 2017. Again, the rules here are very specific and you should review them carefully if you think they might apply.
The next bit of information that you’ll need to provide is whom you’re claiming for exemptions. This will generally be yourself and, if you’re married filing jointly, your spouse. It will also include your children, and possibly others for whom you provide a home. If this is the case for you, read through the Form 1040 instructions carefully. You may find that your chronically unemployed partner and his or her children for whom you provide a home can give you some tax benefit.
Note that for your 2018 taxes — which you will file next year — you will no longer have exemptions due to the recently passed tax reform. But for now, claim ’em while you (legally) can.
Here you will report your income from all sources. For most people, this will at least be salary or wages. This income, received from an employer, will have been reported to you on a W-2 form. You will also report any dividends or interest, unemployment, and alimony that you receive.
Self-employed people will complete a Schedule C or C-EZ and report their self-employment income here. If you have capital gains or losses, you will complete a Schedule D and carry that over. There can be other income as well, such as IRA distributions. But for most working people, it will come from the sources already listed.
You will add all this up to arrive at the first of your totals on your return: your total income.
3. Adjustments From Income
Next you will determine your adjustments from income. The most common will be IRA deductions, educator expenses, the deductible portion of self-employment tax, alimony paid, and student loan interest.
You will determine if these or other adjustments apply, add up your adjustments, and subtract the total of your adjustments from the income total determined in the prior step. This new total is your adjusted gross income (AGI). You will report this number at the bottom of the first page of the 1040 and carry the total to the top of the second page.
4. Tax Deductions
If you’re using Form 1040, you have the option to itemize. If you’re using the 1040A, you have to use the standard deduction. You also have to use the standard deduction on the 1040EZ, but they have helped with the math there by combining a couple of steps.
If you itemize your deductions, you’ll do so on Schedule A of the 1040. On the Schedule A, you will list the taxes you paid, such as real estate taxes or state income tax withholding, mortgage or investment interest, and gifts to charity. You may also be able to include medical and dental expenses (if you had a lot) and certain other expenses, such as unreimbursed employee business expenses.
Once you’ve determined the total of your possible itemized deductions, you will compare this to your available standard deduction and take the bigger of the two, as deductions reduce the amount of income you have to pay tax on.
After determining whether you are itemizing or using the standard deduction, you will calculate the deduction you get for your exemptions. An exemption is a reduction in the amount of income for each person you claimed as a dependent back in the initial section of the return.
For the 2017 tax year, each exemption is worth $4,050. For the 2018 tax year, exemptions will be a thing of the past, but you will have a larger standard deduction available.
Subtract your deduction amount and your allowance for exemptions from your AGI, and you’ll get your taxable income. Write that amount on the return, then look up the tax for it in the tax tables.
Next come credits. Credits are wonderful things if you get them. We just went through deductions, which lower the amount of income you pay tax on. Deductions, therefore, save you money at the amount of the deduction times the tax rate. They’re nice, but a dollar of deduction results in less than a dollar of tax reduction. For example, a $1,000 deduction at a 25-percent tax rate reduces taxes by $250.
Not so with credits! A credit is a direct reduction in the tax you owe. Dollar for dollar.
Your tax is reduced by the amount of the credit. You get the whole thing, the whole enchilada.
For example, a $1,000 tax credit lowers your taxes by $1,000. There are child tax credits, education credits, retirement savings credits, childcare credits, and a couple of others. Not all are refundable.
What this means is that most credits will only bring your tax liability to zero. Your tax liability is the number you calculated a few minutes ago based on your taxable income. You can only take non-refundable credits up to the amount of your tax liability. Refundable credits don’t have that limitation. You will total your credits and subtract them from your tax liability.
6. Other Taxes
In some cases there can be an add-in, which increases your tax liability here. For self-employed people, this will be in the form of self-employment tax. This is essentially the Social Security tax on self-employment income. So it’s not really a penalty for being self-employed, though it may feel that way.
The other big notable here is that this is where the individual responsibility health-care payment goes. Translation: If you didn’t have qualifying coverage under the Affordable Care Act (or Obamacare), this is where you pay the penalty.
You will add up the total here (if any) and add it to the total from above for your total tax. This is noteworthy, so we will pause momentarily.
The “total tax” number is the actual total that you will pay in federal taxes for last year. You have most likely paid this — or perhaps somewhat more — through tax withholding. But if you’re looking for what you give the government for income tax, this is your number.
Here you will input the withholdings you had from any employment income, along with any estimated tax payments.
If applicable, you will also claim the Earned Income Tax Credit (EITC). The EITC is a program designed to encourage people to work. It provides supplemental income based on the amount that you earn and the number of qualifying people in your household. It helps lower-income employees to support themselves by boosting their income.
8. The Bottom Line
Finally, you get to the bottom line. There are two possible outcomes:
One is that you paid in more than your total tax (through withholdings and possibly other methods). If this is the case, then the government will issue you a refund of the amount you paid which is in excess of your tax liability.
The other possibility is that your withholdings and other payments are short of your tax liability. This is when I raise my hand. If this happens, it means that you — and I, too — still owe. The total tax calculated above is greater than the total of what we have given the government so far. We have, in essence, made a down payment, but still owe taxes to the extent that our payments run short of our total liability.
Technically, there is a third option: It’s possible that what you have provided in payments is exactly the amount of your total tax. I have never heard of this happening, but the possibility does exist.
How Do Tax Returns Work? A Recap
There it is. You simply need to identify who you are, what your status is as a taxpayer, and who else is involved here (such as the people you will be claiming as dependents).
You will also provide all your incomes from whatever sources. Some, such as self-employment, will require you to complete another form.
Then you will make adjustments to income for a few things, like an IRA contribution or student loan interest. This will get you to your adjusted gross income, or AGI.
You will see if the sum of your potential itemized deductions — taxes, mortgage interest, etc. — is larger or smaller than your standard deduction. You will claim an exemption for yourself and each of your dependents. Taking these off of your AGI gets you to your taxable income, and you looked up the tax.
You also checked to see whether you had any credits and deducted them from your tax liability.
Then you determined whether you owed anything additional, such as self-employment tax or an individual responsibility payment. Adding these in got you to your bottom line — your total tax liability. You compared this to the total of all of your payments to see if you owe the government — or if they owe you. You probably see that a tax refund is merely an indication that you had too much money withheld; and that if you owe money, you were merely under-withheld.
Now that you have a basic understanding — and less fear — perhaps it’s a good time to look at some next steps. One would be to consider adjusting your withholding so that you won’t be in a position of either owing a lot or getting a large refund next year. To do this, you will next need to get a basic understanding of how the changes in the recently passed tax reform will affect you. This way you can avoid next year’s fear long before it happens.