Our guided tour of the Form 1040 is going pretty well. We looked at the first page yesterday, and now we’re ready to move on the second (and last.)
If we take a look at the process for calculating tax returns, you can see the first page doesn’t get us very far down the list of additions and subtractions. We’ll make a lot of progress on the second page. That being said, things can get a little confusing, so we’ll take it slow. One step at a time.
Also, if you don’t have a copy of a 1040 handy, you can download one from IRS’s website.
Again, here’s a brief overview of how your taxes are calculated:
|– Adjustments to Income|
|Adjusted Gross Income|
|– Nonrefundable Credits|
|+ Other Taxes|
|– Payments and Credits|
|Refund / Taxes Owed|
The 1040 has scads of sections on the second page (which is the page we’re looking at today.) We’ll start at the top.
Standard or Itemized Deduction
After we put our Adjusted Gross Income on the top line (copying from the previous page,) we decide whether or not to use the itemized deduction or the standard deduction. Your tax preparer should be able to succinctly explain which one they are using, why, and how they calculated it. The deduction is subtracted from your Adjusted Gross Income.
The amount of your exemption is based on the number of exemptions you calculated on the first page. It’s then subtracted as well.
After subtracting our deductions and exemptions from Adjusted Gross Income, we find our Taxable Income. This is the number from which our tax is calculated. As taxable income reduces, the income tax reduces. This is also the number that determines our tax bracket. Another important point: since the tax is a percentage of taxable income, using deductions to reduce taxable income is not the same as using a credit to reduce tax.
For example, say you have a $50 tax deduction, or a $50 tax credit.* If you’re in the 10% tax bracket (say, for easy math,) that means your $50 deduction results in a $5 tax savings, while your $50 credit results in a $50 tax savings.
To calculate tax, we take our taxable income and refer to income tax tables to find the amount of income tax.
Alright, fun fact: there are different types of tax credits. One type can reduce your tax, but not below zero, which is pretty nice. These are nonrefundable credits. The other type is totally awesome. It can not only reduce your tax to zero, but you can even get money back from the government. The type is called the refundable credit. In this section, we calculate nonrefundable credits. We subtract these from our tax, but not beyond zero.
Here’s the section where taxes like early withdrawal penalties from retirement plans or self-employment taxes. They are added to your tax.
Oh sweet, joyous happiness! This is the section that makes all the difference. Here’s where you put in your withholding for the year. It’s also where you take those wonderful refundable credits, such as Earned Income Credit, additional child tax credit, and first-time homebuyer credit. These reduce your tax, even beyond zero!
Refund / Taxes Owed
The bottom line: do you need to send in money, or will the IRS send you money?
Don’t forget to sign! This is a pretty straightforward section.
In review, on the first page, we filled out:
- The label – enter our identifying information
- Filing Status – determine what type of taxpayer we are
- Exemptions – determine how many dependents we have and how many exemptions we can take
- Income – determine how much money came in this year, and find our Gross Income
- Adjusted Gross Income – determine what expenses/adjustments we can subtract from our Gross Income in order to calculate our Adjusted Gross Income.
On the second page, we filled out:
- Deductions – do we have expenses that are deductible, or should we take the standard deduction?
- Exemptions – subtract exemptions
- Taxable Income – determined the amount of income subject to tax
- Tax – determined tax
- Nonrefundable Credits – how to reduce tax, but not less than zero.
- Other Taxes – increase tax by adding other taxes
- Payments – determine withholding and any refundable credits.
- Signature – sign that puppy!
Now that you understand a bit about the structure of you tax return, you can feel empowered to understand the return you tax professional prepares, and feel confident that you’re signing an accurate return.
* You see these sorts of decisions more when you’re choosing between education credits, such as the lifetime learning credit, and tuition and fee deductions.