Tax season is upon us once again. While most people are afraid of taxes, I see it as a challenge to overcome. Successful millionaires learn to work with taxes, and incorporate them into their financial plans. To overcome that fear of taxes, I’m going to explain what a 1040 is and how to read one.
A 1040 is the individual income tax form that you file every April 15 with the IRS. You report your income and certain expenses on it, and it calculates how much taxes you either owe or will get back. The top part is your personal and contact information, like your name, address, and social security number.
The next part is your Filing status. You’re either single, married filing jointly, married filing separately, head of household, or qualifying widow with dependent child. If you’re single or engaged by December 31 of the year, you file single. If your married filing jointly (MFJ), the IRS treats you and your spouse as a single entity. Most married couples file MFJ. Married filing separately (MFS) is just as it sounds. You’re married, but your each filing separate returns as if you’re single. There are pros and cons to filing MFS. Head of Household (HH) is designed for those who are not married, but are substantially supporting someone (there is a specific definition for support). Lastly, qualifying widow with dependent child allows widows or widowers with children to retain the benefits of MFJ for two years.
The next section is the Exemptions. An exemption is a yearly amount that is deducted from your taxable income to reduce your tax liability. The 2016 personal exemption is $4,050.00, and increases every year. Generally speaking, there is an exemption for every person that the tax return covers. For example, if you’re single, you only get one exemption. If you’re married with two kids, and filing MFJ, you get four exemptions, one exemption for each person.
Now we come to the main parts of the 1040. The Income section is where you report all the income you received for the year. Basically, everything is taxable unless it is explicitly stated in the IRS code that it is tax exempt. Taxable income includes your wages, interest and dividends, selling stock, certain retirement distributions, and personal business and farming. It also includes alimony received, unemployment compensation, lottery winnings, social security, and many other less common items, such as forgiveness of debt.
Nest is the Adjusted Gross Income section, commonly referred to as your AGI. It’s a widely used figure calculated by subtracting specific deductions from total income. Common deductions may include educator expenses, health savings account (HSA) contributions, moving expenses, IRA contributions, student loan interest expenses, and tuition expenses.
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There are additional deductions, but they are less common. All of these deductions are referred to as above the line deductions, because the IRS allows you to deduct them to calculate your AGI “line”.
On the second page of the 1040, is the Tax and Credits section. This section calculates your taxable income by deducting the exemptions previously discussed and either the standard deduction or your itemized deductions from your AGI. The standard deduction is a flat amount that you are allowed to deduct from your AGI to lower your taxable income. Or you could itemize your deductions and keep track of receipts and records for certain expenses. There are lot of rules to itemizing your deductions, which is why you only itemize if it’s higher than your standard deduction.
Once you’ve calculated your taxable income, the next two lines are the taxes and alternative minimum taxes calculated based on your taxable income. The alternative minimum tax (AMT) is a supplemental income tax on those who are in the position to use tax loopholes to avoid paying taxes, i.e. wealthy tax payers. Most taxpayers do not have to deal with AMT tax.
Once you have calculated your taxes, you now calculate how much in tax credits you get to offset your taxes. Tax credits reduce your taxes dollar for dollar, whereas deductions reduce your taxable income, from which taxes are calculated from. Most people are familiar with child and dependent care credits, education credits, retirement savings contributions credits, child tax credits, and residential energy credits. There are also credits for getting health insurance through the health insurance market place (while it’s well known, it’s relatively new), and many more credits that affect only a few taxpayers.
Once you’ve calculated your tax credits, you calculate even more taxes in the next section, called Other Taxes. Fortunately, these taxes are not common, and affect only a small group of taxpayers.
You’ve now calculated the taxes on all your activity for the year, and reduced it by all the tax credits you’ve also earned for the year. It’s time to figure out how much of those taxes you’ve already paid, which you do in the Payments section. That’s why you have to file a tax return every April, to reconcile the taxes you’ve already paid with the taxes you should have paid. Most people pay the most taxes from their paychecks, which comes from the W2s, or less commonly, 1099s. Some people are unfortunate enough to have to prepay taxes for the next year by making estimated tax payments. Others forgo their tax refund and apply it to their upcoming taxes the next year.
There are also some additional less common tax credits that get applied here that increase your tax payments. You add all those up, and get your total tax payments that you have made during the year.
We are now at the last main part of the 1040, the Refund and Amount You Owe. If you’re total payments is more than your total tax, than you overpaid your taxes. This overpayment can be refunded back to you or applied to your taxes next year. If you underpaid, then you owe taxes (and penalties) in April.
That brings us to the bottom of the 1040, where you, and your tax preparer, sign and date the tax return. And there you have it. A 1040 basically totals up all your income, deducts certain above the line expenses to calculate your adjusted gross income (AGI), deducts additional below the line expenses to calculate your taxable income, and then deducts tax credits (and adds less common taxes) to calculate your total taxes. Lastly, it calculates your total payments and tax credits to determine whether you overpaid or underpaid.