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Q. Can you explain the tax process? How is the final amount of tax I owe calculated? A. It all begins with income -- which, for most of us, is automatically reported to the IRS. Our employers report what was paid to us as salary. Our banks report interest we earned. Our brokerages report dividends paid to us and stocks that we sold (for which we'll need to calculate our gains or losses). You may need to report additional income sources, too -- such as tips, gambling winnings, business income, rental income, alimony income... or the million dollars you won on that DMV-Castaway show after being locked up in a Department of Motor Vehicles office for three months with a dozen strangers and a registration to renew. (Just remember, we thought of it first.) Total all your income for the year, and you'll be looking at what's called your "gross income." To this, you now make "adjustments": Once you've made all your adjustments, you'll be left with a very important sum: your "adjusted gross income," or "AGI." The AGI is used throughout your tax return -- expect it to pop up all over the place, like the little critter in carnival "Whack-a-Mole" games. It's used to determine limitations on a number of tax issues, including exemptions, deductible IRA contributions, and itemized deductions. From your AGI, you now claim your exemptions and make your deductions. You can take either an itemized deduction or a standard deduction -- whichever is greater. The standard deduction ranges from about $3,500 to $7,000, depending on your filing status. You're entitled to one exemption for yourself, plus one each for your spouse and/or dependents, if you have them. The exemption is a set amount that you're permitted to deduct from your income, reducing the sum on which you're taxed. Exemption levels are tied to inflation and change from year to year, usually increasing. Once you've taken your exemptions and deductions, you're left with your "taxable income." It's this number that determines your tax. (Just flip to the tax charts, which tell you, for example, that -- if your taxable income is at least $35,300 but less than $35,350, and you are single -- your tax is $6,596.) Sound simple enough? It is -- except that we're not done yet. Although you may think this is the total amount of tax that Uncle Sam would like you to cough up, there are still a few steps to go. You now subtract any credits from the taxes due. Then you add any other taxes. Credits are usually for children, the elderly, the disabled, adoptions, or foreign taxes paid. Other taxes include self-employment taxes and taxes on qualified retirement plans. The end result is your total tax. This is the sum that you must fork over to the government. You're not going to sit down and write a check for this amount, though, because there's one step left. Remember all that money withheld from your paycheck every payday? Or the estimated tax payments you've already made? Items like these are subtracted from your total tax, leaving you with either a positive or negative number. If the number is positive, make a check out for that amount and send it to the IRS. If it's negative, you can expect a tax refund in that amount. That's it -- you're done. It does take a while to do (it's estimated that upwards of 30 hours is required to complete Form 1040 and Schedules A, B, C, and D), but it isn't brain surgery. Learn more in our online Tax Strategies area, or in our hot-off-the-presses book, The Motley Fool Tax Guide 2002. This question and answer is adapted from The Motley Fool Money Guide: Answers to Your Questions About Saving, Spending and Investing. For answers to this and 499 other common money questions, check it out -- it's a handy resource (and a terrific holiday gift!).
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