Ever wonder how the final amount of tax you owe is calculated?
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."
- Subtract whatever amount you contributed to qualifying IRA or other retirement accounts.
- Subtract any alimony payments you made and any moving expenses that qualify.
- If you're self-employed, subtract half of the self-employment tax you paid.
- Subtract any qualified student loan interest paid, and any medical savings account deduction.
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. (You just flip to tax charts, which may 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 take the tax due on your taxable income and subtract any credits. 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, it's what you have to make a check out for. 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.
And by the way, this is exactly the kind of topic that a financial advisor can help you with. Learn how to find one at our Advisor Center -- and perhaps check out our TMF Money Advisor service, which features customized independent advice from a variety of objective financial experts.