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!

Throughout the year, a variety of things that affect your income taxes can happen. In the United States, a personal income tax return is a set of forms provided by the Internal Revenue Service (IRS) which most residents are required to complete every year. Most financial transactions and important life events will be entered into your tax return so that you can calculate exactly how much income tax you owe to the federal government.

Typically, you pay some amount of income tax through withholdings (see What is: Withholding) throughout the year, but your withholding amounts are only estimates. After you complete your tax return, you’ll find out how close the total withholding is to your actual tax owed.

Typically, each of your paychecks shows deductions for Social Security, Medicare, federal tax, and state tax. These items amount to your withholding–the portion of your pay that is withheld. These amounts are sent by your employer to the Internal Revenue Service (IRS), an agency of the U.S. government.

At the end of the year, you’ll receive a form that shows the total amounts withheld from you throughout the year. The information on this form will help you complete your tax form, which will determine the size of your tax refund or balance due.

IRS Form 1040 summarizes your tax information for the year—Some numbers come from additional forms called “Schedules”

All Income is everything that you received during the year.  Some income, such as tax-free gifts, is excluded, which is why Total Income can be less than All Income.

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I remember sitting in my tax class and hearing this question all the time. Here’s my best attempt at an explanation:

First off – your Adjusted Gross Income (AGI) is the most important number in determining your taxes.

Did you have tuition expenses you were hoping to get back from Uncle Sam? Did you hire a nanny to babysit your kids and want to get some of that money back through the Child-Care tax credit?

A lower AGI means a better chance of being able to answer yes to these and other questions that will lower your taxes.

For example, the government will help you pay your expenses for a babysitter or a nanny.

If your AGI is below $15,000 – the government will help pay 35% of your child-care expenses. If your AGI is above $43,000 – the government will help pay 20% of your child-care expenses. If your AGI is between $15,000 and $43,000 – the government will help you pay somewhere between 20% and 35%. (See here for complete eligibility requirements)

Now that we’ve seen one way AGI is used, let’s go back to the difference between Deductions for AGI and Deductions from AGI.

Let’s consider the story of two taxpayers – Angela and Bob. Angela and Bob both made $43,000 in 2008. Both Angela and Bob spent $3,000 on a babysitter. So far they are the same. Here is where things get different: Angela has a $5,000 deduction for AGI (unrelated to child-care), and Bob has a $5,000 deduction from AGI (also unrelated to child-care).

Angela’s AGI is $38,000 (income of $43,000 minus the $5,000 Deduction for AGI) and Bob’s AGI is still $43,000 (the Deduction from AGI doesn’t change his AGI). The government will give Angela more money back for the babysitter. Why – because she has a lower AGI.

In general, you want a Deduction for AGI instead of a Deduction from AGI. The IRS decides what expenses are a Deduction for AGI, a Deduction from AGI, or neither. The more you are able to take advantage of Deductions for AGI, the more you will be able to legally reduce the amount of taxes you pay – no matter what your income is.

What effect do mortgage payments have on my income tax?

If you borrowed money to buy the home you live in, you might be able to deduct some of your mortgage payments.   If you have a standard mortgage, you pay back the original amount you borrowed (the principal) plus a little more for the privilege of paying it back over time (interest).

You can deduct these interest payments from your taxes.   Mortgage interest is a deduction from AGI.   If all of your deductions from AGI are more than the standard deduction, your mortgage payments will reduce your income taxes.

For complete eligibility requirements and instructions on deducting mortgage interest, download this.

More Links

NYTimes Economix Blog – Killing (or Maiming) a Sacred Cow: Home Mortgage Deductions

Fast Company -Why You Can’t Afford Tax Ignorance