Fortunately, you don’t owe tax on every last nickel.
If you’re looking for the bright side of paying income taxes, consider this: Your taxable income—the amount of income that’s the base for calculating what you owe—is always less than your total income, sometimes called your gross income.
That’s because the tax law—officially the Internal Revenue Code—lets you deduct certain amounts from your total income in figuring your taxable income. And you may even be able to subtract credits to reduce your actual tax.
TAXING THE UNEARNED
Remember, you also owe tax on unearned income from your savings and investment accounts.
If you sell investments for more than you paid for them, you owe capital gains tax on your profit. Long-term gains on most assets you own for more than a year before you sell them are taxed at a lower rate than short-term gains or earned income. But they’re still taxed.
If you’re paid interest on a savings account, certificate of deposit (CD), or bond, you owe tax on that amount even if you leave the interest in your account to compound. The same is true for dividends you receive on stocks or mutual funds, whether or not you reinvest those earnings. The good news is that the tax on most dividends is figured at the long-term capital gains rate.
Banks, brokerage firms, mutual fund companies, and other financial institutions typically don’t withhold income tax on the interest or dividends they pay you. So you have to estimate the income you anticipate each year. If it’s substantial, you can either increase the amount you have withheld from your earned income or pay estimated taxes.
WORKING THE NUMBERS
The process of finding the tax you owe begins with totaling your income. You add up all your earned and unearned income, including basic things like your salary, tips, interest, and bonuses. Your income may also include a list of things that might not occur to you, such as sick pay and unemployment. The IRS provides a fairly exhaustive list in the instructions that come with tax forms and in Publication 17, “Your Federal Income Tax.”
The next step in determining your taxable income—which determines the tax you owe—is calculating your adjusted gross income (AGI) by subtracting your adjustments to income, or certain specific expenses listed on the tax form you use. (If you’re eligible to use the 1040EZ, the process is a little different, but it’s clearly spelled out on the form itself.)
Among the adjustments that will probably be relevant to you at this stage are interest on student loans, contributions to deductible IRAs or self-directed retirement plans, such as Simplified Employee Pensions (SEPs), self-employment taxes, and alimony you pay.
Next, you subtract exemptions and deductions from your AGI to find your taxable income.
You get one exemption for yourself, two exemptions if you’re married and filing a joint return, and one for each of your dependents. The exemption amount is indexed to inflation, so it changes a little bit each year.
In some years, there are exceptions to the general rules on deductions, so it always pays to check if you qualify for additional savings that would reduce your taxable income. For example, you can deduct any financial losses you suffered as result of a federally declared disaster, such as a fire, tornado, hurricane, or flood.
If you’re going to claim someone as a dependent and take an exemption, that person must qualify by meeting five tests, or standards, the IRS describes in the instructions provided with your tax return. People other than your children may pass the tests, but the rules are rather strict.
You can take either the standard deduction, an amount that covers certain personal expenses, or you can itemize, or list, your deductions and take that amount if it’s higher than the standard. Most people don’t bother itemizing, but if you have mortgage interest and real estate taxes, charitable contributions, or certain other expenses, itemizing may pay off in lower taxes.
But the only medical expenses you can deduct are amounts you paid out of pocket during the year, that were not covered by insurance, and that are more than 10% of your AGI.
THE BOTTOM LINE AND BELOW
Once you know your taxable income, you look up the tax that’s due on the tables the IRS provides, or, for taxable income over $100,000, calculate the amount you owe. Everything you need is in the instructions that come with your form.
SOME FREE LUNCH
A few—but not many—sources of income aren’t taxed if you’re on the receiving end, including gifts, tuition scholarships and some fellowships, tax-exempt interest from municipal bonds, and child support payments.
Next, you subtract any credits you qualify for. Credits are better than deductions or exemptions because they directly reduce the tax you owe, not your taxable income. But you have to qualify for them, usually by having spent money on things like education, foreign taxes, childcare or adoption expenses, or care for elderly or disabled dependents. Each credit requires that you attach an explanatory form to your tax return, and there are income and other restrictions that may limit your ability to claim some or all of them.
Finally, you compare what you owe with what you prepaid to see if you get a refund or have to write a check.