Every year as April 15 looms closer, various bits of mail begin showing up at our homes with messages like “Important Tax Information” and “Form 1099-INT”.  We slowly become aware of something called a “tax return” that needs to be completed and sent to a faraway place called the “IRS”.  So every year, we try our best to use a $30 box of software to fill in the forms ourselves, send them away electronically, and hope it was done right.  Or, we try to gather all of the mail, paperwork, and receipts, and then pay someone else to fill in the forms for us… and hope it gets done right.

Do we ever fully understand what’s in our tax return? No.  But that’s okay, because it’s not because we aren’t smart enough—it’s difficult because the IRS made the tax code incredibly complicated.  To make it even harder, the tax laws also change every year!

The Individual Income Tax Return is what we must deal with every year.  It’s based on Form 1040, which is the primary piece of paper that summarizes a person’s income and taxes for the past year.  People with more complicated financial situations have to find and complete other forms, and then enter those results on Form 1040.

Let’s walk through each section of the 1040.

Exemptions are calculated based on information about your household. If you are married, raising children, or supporting other family members, you will get to take a greater number of exemptions, which will reduce your income tax. Each exemption you take reduces your Taxable Income by $3,650.

Here, the word Income means everything that qualifies as income under the IRS’ definition, such as wages, salary, business income, interest income, and investment gains.  Certain things like alimony and employer-paid health insurance are outside this definition, so they don’t need to be included in your tax return.

First, let’s explain Deductions.  Deductions are items that the IRS allows you to subtract from your income.  Lower income means less income tax due.  That’s a good thing.  These deductions include things like 401k contributions, business expenses, and moving expenses.

AGI stands for Adjusted Gross Income.  AGI is important because it determines your tax rate (from 10% to 35%) and also affects how much state and local tax you owe.  Basically, you start with your Income, take these deductions to get AGI, and then use the AGI number to finish your Federal tax return and complete other forms like state returns and financial aid forms for college.

AGI = Adjusted Gross Income. It’s an important number.

Deductions from AGI are less beneficial than Deductions for AGI because they have a smaller impact on the amount of tax you will owe.  Deductions from AGI will consist of either a Standard Deduction or a list of Itemized Deductions.  Itemized Deductions are things like mortgage interest, charitable donations, and medical expenses.  For most people, their total Itemized Deductions are not greater than the Standard Deduction, so most take the Standard Deduction, which for 2010 is $5,700 for a single person, $8,400 for the head of a household, and $11,400 for a married couple completing their tax return together. There are other amounts set for other types of taxpayers.

After this step, you now know your Taxable Income.

Now we’ve arrived at the main point of this painful procedure—to answer the question, “How much tax do I owe this year?”   Your Income Tax is calculated based on the Taxable Income number as determined by the previous steps.  To find out the exact amount of Income Tax, you can look up your Taxable Income starting on page 74 of the IRS’ 1040 instructions.

Credits are additional discounts that the government offers to certain groups of people.  For example, you may be qualified to take credits for education expenses, child care expenses, the cost of purchasing a new home, or other credits for military personnel.  After calculating your income tax, these credits are applied so that you can get off the hook for that portion of your income tax.

Other Taxes aside from standard personal income are added here.  This includes taxes on self-employment, social security and Medicare, IRAs, and other qualified retirement plans.

This is the final step.  Throughout the year, your employer probably took out a portion of your paycheck and sent it to the IRS to pay some of your income tax in advance on your behalf.  Those Payments were an estimate of how much tax you would eventually owe at the end of the year.

The purpose of completing the tax return, and this step in particular, is to compare how much tax you already paid to the government to how much your tax return says that you owe after doing all of the calculations based on your unique financial situation.

If the estimated tax taken from your pay was too much, you will get a refund.  If the tax paid through the year wasn’t enough, then you’ll have to make an additional payment to cover your total taxes for the year.

It’s finally over!

The end result is that Medicare, Social Security, Federal tax, and State tax add up to about 25% of your income, and the other 75% is what you get to keep for yourself.   Spend it wisely!