Image art by Jonan Everett
This time of year can bring longer days, shorter nights — and with them, a touch 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.
Most years, before April 15, you must file a return based upon last year’s information — provided you haven’t already filed for an extension. However, due to developments related to COVID-19, this deadline has been extended to July 15, 2020. If you’re among the multitudes who dread the thought of navigating your own return, here’s a simple explanation of how taxes work, an anatomy of your forthcoming tax return.
Understanding Taxes: The Different Kinds of Returns
There are two versions of federal returns for personal income taxes: Form 1040 and Form 1040-SR. Most filers will fill out a Form 1040, as the 1040-SR is reserved for use only by individuals over 65 (though individuals over 65 can still use a regular 1040, if they so choose).
Previously, taxpayers had the choice of using a 1040, 1040A, or 1040EZ. The 1040-A, or 1040EZ forms were eliminated with the passing of the Tax Cuts and Jobs Act of 2017, with the intention of simplifying filing for Americans.
Individuals using the 1040 can opt to take the standard deduction or to itemize their taxes, whereas individuals using a 1040-SR must take the standard deduction.
Whether or not you itemize your taxes will likely be determined by the type of work you do, and how much you spent related to your employment in the past year. For example, if you’re operating your own business and had a lot of overhead costs in the past year, you may benefit more from deducting each item individually rather than taking the standard deduction.
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.
How Do Tax Returns Work? The Step-by-Step Process
Your 1040 begins 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.
Your 1040 will require that you 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).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 — they could very well be your parent, stepparent, or your sibling, provided you have paid more than half their financial support and they have lived with you for more than half of the past year.
The status of “qualifying widow(er)” is for a person whose spouse died in 2017 or 2018, who has remained unmarried through the end of 2019, and who has provided a home for a dependent child throughout 2019. Again, the rules here are very specific and you should review them carefully if you think they might apply.
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 or 1099 form. You will also report any dividends or interest, unemployment, and alimony that you’ve received.
In addition, self-employed filers 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.
2. 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 your 1040 and carry the total to the top of the second page.
3. Tax Deductions
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.
Keep in mind that many of these deductions have thresholds, such as deducting up to $10,000 in state and property taxes, and deducting interest on a mortgage up to $1 million.
Once you’ve determined the total of your possible itemized deductions, you will compare this to your available standard deduction and take the larger of the two, as deductions reduce the amount of income on which you have to pay tax.
Subtract your deduction amount 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, credits for the usage of renewable energy (like solar panels), and a few 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 take non-refundable credits only 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.
5. 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.
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.
7. The Bottom Line
Finally, you get to the bottom line. There are two possible outcomes:
One is that you’ve already paid 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 in excess of your tax liability.
The other possibility is that your withholdings and other payments are short of your tax liability. If this happens, it means that you still owe. The total tax calculated above is greater than the total of what we have given the government so far. You have, in essence, made a down payment, but still owe taxes to the extent that your payment runs 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 income 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 (AGI).
You will see if the sum of your potential itemized deductions — taxes, mortgage interest, etc. — is larger or smaller than your standard deduction. Taking these off of your AGI gets you to your taxable income, then you look up the tax.
You also check to see whether you have any credits and deduct them from your tax liability.
Then you determine whether you owe anything additional, such as self-employment tax or an individual responsibility payment. Adding these in gets you to your bottom line — your total tax liability.
You compare this to the total of all of your payments to see if you owe the government — or if it owes 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.
Additional background information for this article was provided by Vincenzo Villamena, CPA.