Taxes can be confusing, but understanding the basics – tax terminology and how taxes are computed – can help you save money and avoid penalties.
According to Julie Welch, CPA, PFS, a managing partner and director of taxation at Meara Welch Browne and coauthor of “101 Tax Saving Ideas,” you can better understand your taxes by grasping the following:
Tax terminology
There are many different tax terms you may need to know to understand your taxes. Some of the most common tax terms include:
- Total income
- Adjusted gross income
- Standard deduction and itemized deduction
- Taxable income
- Credits
- Total tax
- Total payments
How taxes are computed
Taxes are computed based on your income and deductions. Your total tax for the year will vary depending on your filing status, income, deductions, and credits. So, let’s look at the tax formula.
Determining your total income
All income used for determining your tax for the year, which can be found on lines 1-9 of Form 1040, is the starting point in the tax formula, according to Welch. The most common income items are wages, interest, dividends, alimony (only if you received it under a pre-2019 divorce agreement), business and rental income, gains or losses from the sale of property, and retirement income from IRAs, pensions and annuities.
Certain income items are not included in income, according to Welch. The most common examples are gifts, life insurance proceeds, scholarships used to pay for tuition and fees, and fringe benefits such as employer-provided life and health insurance.
All income, except those income items that Congress chooses not to tax, equals total income (line 9 on Form 1040) or what Welch refers to as gross income.
Adjusted gross income
Next, you’ll need to get a handle on something called adjusted gross income or AGI. Subtracting adjustments to income from Schedule 1, Additional Income and Adjustments to Income, line 26 from your total or gross income results in your adjusted gross income.
Of note, the most common adjustments to income include:
- Student loan interest
- Alimony (only if paid pursuant to a pre-2019 divorce agreement)
- Deductible IRA contributions
- Qualified disaster losses
- Business expenses, and
- Rental expenses
Welch says AGI is important because some itemized deductions, such as medical expenses, are not deductible unless they exceed a percentage of AGI, and some deductions and tax credits are reduced or eliminated based on your AGI.
AGI is also important because it is the starting point for the calculation of tax on many state income tax returns, Welch says. Thus, in many states, the lower your federal AGI, the lower your state income tax.
From AGI, Welch notes that you can deduct either itemized deductions (from Schedule A) or the standard deduction. Itemized deductions are also called below-the-line deductions and personal deductions.
These include:
- Medical expenses to the extent they exceed 7.5% of AGI. This means that only the amount of medical expenses that exceeds 7.5% of your AGI can be deducted. There is no different percentage for older taxpayers.
- State and local income taxes, and real estate and personal property taxes (or you can deduct sales tax paid instead.) These are limited to $10,000, or $5,000 if married filing separately.
- Home mortgage interest and points and investment interest expense to the extent of interest income
- Charitable contributions of cash and property, and
- Gambling losses and gambling-related, non-wagering expenses to the extent of gambling winnings.
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Now the sum of your itemized deductions is compared to your standard deduction. The standard deduction is set by the federal government and adjusted for inflation each year. The standard deduction varies based on your filing status, but there are different deduction amounts for taxpayers who are claimed as a dependent, over 65 and/or blind.
To arrive at the amount of deductions from AGI, you compare your standard deduction with the sum of your itemized deductions. Your deduction from AGI is generally the larger of the two amounts.
You cannot claim both your itemized deductions and your standard deduction on the same return. You must choose one or the other, Welch says.
Also of note, the 20% of qualified business income (QBI) deduction is a deduction from AGI for owners of sole proprietorships, partnerships, shareholders in S corporations, some trusts and estates and certain real estate investors.
The QBI deduction — which is also called the Section 199A deduction — is the net amount of qualified items of income, gain, deduction, and loss from any qualified trade or business, including income from partnerships, S corporations, sole proprietorships, and certain trusts. Generally, this includes, but is not limited to, the deductible part of self-employment tax, self-employed health insurance, and deductions for contributions to qualified retirement plans (e.g., SEP, SIMPLE and qualified plan deductions). Read: Qualified Business Income Deduction(IRS).
Taxable income
Next, you’re going to add the amount on Form 1040, line 12 (either your standard or itemized deduction) and your qualified business income deduction (from Form 8995 or Form 8995-A) and subtract that sum from your AGI (Form 1040, line 11). And the result will be taxable income (Form 1040, line 15).
According to Welch, your tentative tax is calculated on this amount.
By way of background, when your taxable income includes dividends and/or long-term capital gain income from mutual fund distributions or the sale of property, such as stock, you should use Form 1040, Schedule D and the special worksheet to calculate your tax on these items.
Tax
Additional taxes you may be subject to include self-employment tax, 10% penalty tax on early distributions from retirement accounts, and the 3.8% tax on net investment income.
Of note, You will use either the tax tables or the tax rate schedules to calculate your tax. The tax rate schedules differ by filing status, and all of the filing statuses are subject to the progressive rates of tax – 10%, 12%, 22%, 24%, 32%, 35%, and 37%, but these rates apply to different levels of income depending on your filing status.
Of note, your tax bill before credits and payments are calculated will be found on Form 1040, line 16.
Credits
Now, the tax on line 16 is “tentative,” according to Welch, because it may be increased by additional taxes or decreased by credits.
Credits are like deductions, only better, Welch says. That’s because credits reduce tax rather than taxable income. Thus, dollar for dollar, you would rather have a credit than a deduction, she says.
The most common credits claimed by individuals are, according to Welch, the child tax credit and the credit for child and dependent care expenses. Other credits include the American Opportunity tax credit, the Lifetime Learning credit, the retirement saver’s credit, the elderly and disabled credit, the adoption credit, the foreign tax credit, energy credits, and the earned income credit.
Credits may be refundable or nonrefundable. With nonrefundable credits, the excess credit is lost or carried over to the next year if the amount exceeds your tax liability. It is not refunded. Some nonrefundable credits, such as the foreign tax credit, can be carried over to other years if they exceed the current year’s tax liability, according to Welch.
If a refundable credit, such as the earned income credit, exceeds your tax liability, the excess, or a portion of it, is refunded to you.
Of note, your total tax bill will be found on Form 1040, line 24.
Payments and refunds
Next, you will determine how much you’ve already paid in taxes to the federal government – your total payments, inclusive of refundable credits. And then you will calculate whether you’re getting a refund or whether you owe the federal government more money (Form 1040, line 37 and line 38 if there’s an estimated tax penalty.
And that’s your form 1040 in a nutshell.
Editor's Note: The content was reviewed for tax accuracy by a TurboTax CPA expert for the 2022 tax year.
Robert Powell is editor and publisher of Retirement Daily on TheStreet.
