For my first 3 years out of college, I worked at a public accounting firm, meaning that from New Year’s until April 15th, I spent 90% of my waking hours tearing through audits and tax returns. And as much as all of you hate doing your own, imagine doing 50 of them, all for people who have 30 investment accounts and piles of charitable contributions to organize. Oy vey.
Thankfully, I switched jobs and no longer have the dreaded “busy” season, but I did take away quite a bit of knowledge as to how those lovely tax returns work. So before I get into the more detailed portion of the blog, here’s the crash course in what you need to know before we start.
1) The federal individual tax return is called a 1040.
2) Due date to file a return is April 15th.
3) If you are single and earned more than $10,000or married filing jointly and earned more than$20,000 ($10,350/$20,700 for 2016) or paid income taxes through your paycheck, you need to file.
Alright, got that? Perfect. Let’s continue.
For most of us, our 1040s aren’t that hard – we have a W-2 (which you will receive from your employer), maybe some interest income from a savings account, student loan interest, etc. However, taxes still tend to be overwhelming to some, especially for those of you who haven’t had the opportunity to prepare hundreds of them. Therefore, I’ve included some of the key terms and info you need to know when preparing a return – I promise, they’re simpler than they seem at first glance ;)
1) Personal Exemption
In my book, this and the standard deduction are considered to be “freebies” – the government is basically saying, “Oh, you earned $40,000 this year? Let’s give you $5,000 that you don’t have to pay taxes on.” For 2013, the personal exemption amount is $3,900 ($4,050 for 2016), and this applies to you, your spouse, and any dependents you claim on your return; therefore, if you are married and have one child, your total exemptions will be $11,700 for the three of you, which will decrease the income you are taxed on. Great, right? Just note, if you’re a college student and your parent claims you on their tax return, you don’t get this exemption. Sorry!
2) Standard Deduction vs. Itemized Deduction
You automatically are entitled to claim one of these on your tax return (in addition to the personal exemption) – so what’s the difference between the two?
The standard deduction is another free pass in addition to the personal exemption and amounts to $6,100 for those filing single and $12,200 for married folks ($6,300/$12,600 for 2016). College students, you again get screwed on this. You can only claim the larger of a) $950 or b) your earned income (think wages from your job) plus $300 – and remember, you can never claim more than the standard deduction amount of $6,100.
Itemized deductions include deductions for things like medical expenses, real estate taxes, home mortgage interest, charitable contributions, state income taxes, etc. The great concept behind these is that the amount of itemized deductions you can claim isn’t capped (unless you earn too much money, but I doubt any of us are in that bucket). Thus, if your total itemized deductions are $10,000, you get to deduct that amount from the income you’ll be taxed on. If they’re below the standard deduction amount, you will automatically get bumped to the standard deduction. What’s better yet? If you use software like TurboTax do prepare your return, it will calculate which deduction to take automatically.
3) Adjusted Gross Income (AGI)
I know this term sounds frightening, but all it boils down to is your total income for the year less certain deductions (if you want the full list of those deductions, just google “above the line adjustments”). This is the last number listed on the first page of your 1040 and is significant because it is used to calculation certain deductions and credits. Note, your personal exemptions and standard/itemized deductions are not yet taken out of this number.
4) Taxable Income
Another simple concept: take that AGI from the first page, deduct your personal exemptions and standard/itemized deductions, and voila! You have your taxable income. This is the amount that you are directly taxed on, and the 2013 tax rates for single and married filers are listed below.
5) Deductions and Credits
Let me break this down for you: Deductions decrease your overall taxable income. Credits decrease your overall taxes. So what exactly does that mean? Here’s an example:
Let’s say you’re single, have taxable income of $25,000, and you have a choice between taking a $2,000 deduction or a $2,000 credit. By taking the deduction, you will lower your taxable income to $23,000, and your overall tax liability will go from approximately $3,300 to $3,000, saving you $300. Looking at it from a different angle, a deduction will basically save you the amount of the deduction times your tax rate ($2,000 x 15% = $300).
On the flip side, because credits decrease your overall taxes and not taxable income, taking the $2,000 credit will decrease the amount of taxes you owe to $1,300 (original liability of $3,300 - $2,000 = $1,300). Moral of the story? Credits are the king of the castle.
Whew, I think that’s enough for today. Hopefully this gives you more insight into understanding your tax return, and since it’s something you’ll have to deal with every year for the rest of your life (sounds daunting, doesn’t it?), it’s best to have some basic knowledge of what is actually going on. For your viewing pleasure, I’ve also included a link to the federal 1040 tax return.
If any of you have questions, please let me know. As always, though, remember to consult your accountant or financial advisor before making decisions on your specific situation. Now go and get yourself that refund!