Absolute Basics: Individual Income Taxes
One of the things I’ve learned by going back to school is how much I didn’t learn the first time around. My parents always took care of my tax return, even through most of college. Since then, The Fiery One and I have used various tax prep software packages to do our taxes.
But I never felt all that comfortable with what I was doing. I trusted the software, and most of the questions seemed pretty straight forward, but I now recognize that I could have easily made some pretty serious mistakes (looking back, I don’t think I did, luckily). And being audited by the IRS is just about the last thing I want. Like many of you, I’d wager, I fall into the category of taxpayers who would rather be very conservative and report everything possible than risk being audited. That remains true even when I know that an audit isn’t the end of the world and can usually be settled fairly quickly and seamlessly.
So here are some tax basics I should have been more familiar with throughout the years. These are Absolute Basics, so you may want to just skim through and pat yourself on the back for knowing everything already. That said, it’s surprising how many people go out and pay a few hundred dollars for someone else to do their taxes when they could easily save the money and do their own tax return in an hour or two.
Either way, considering the IRS holds individual taxpayers responsible for understanding and abiding by all of their rules (meaning they don’t care when you say, “I didn’t know . . .”), we should all know the fundamentals before doing our own taxes:
Forms You Need to Prepare for the IRS
Form 1040 – “Home Base”: Every individual (as opposed to business) tax return is filed on some version of form 1040. Everyone can use form 1040. The other versions, 1040a and 1040ez, have fewer lines for less complicated taxpayer situations (like not owning your own business and not having dependents). In the end, the important thing to remember is that form 1040 is home base. It’s where everything begins and ends.
Backup Schedules: These are not as scary as I once thought they were. They exist to help you fill out the 1040 correctly and show more detail than can be shown on the 1040. All they do is support form 1040. Schedule C, for example, is used for detailing business profit and loss. So if you earn money other than as an employee of a company, you fill out Schedule C by showing your revenue and expenses. Schedule D is used for capital gains and losses. If you sold stock during the year for a profit or a loss, it goes on Schedule D, which helps you figure out how much to show on the 1040 as income or loss.
Worksheets: These generally don’t have to be included with form 1040 and the backup schedules. But worksheets can be extremely helpful in calculating the amounts that must be included on form 1040, and you find them in the 1040 instructions (they’re referenced on the 1040 by page number next to individual line items. Whenever it says “See page . . .” that means check the instructions for details or worksheets).
Tax Forms You Might Receive or Need to Find/Request (from Employers, Banks, Mortgage Companies, Brokers, Retirement Accounts, Schools, etc.)
W-2: If you have an employer, they should send you a W-2 that states your wages and taxes withheld (meaning your employer may have already paid some of your wages to the government in the form of Federal, Social Security and Medicare withholdings. Your W-2 should also show if you’re participating in a retirement plan at work (like a 401k) and the amount of your contributions that were not taxable (for a 401k, that’s your entire contribution). You can have as many W-2’s as you have jobs, and you use them to fill in your Wages, Salaries and Tips (note: if your employer didn’t include all of your tips, you’re supposed to add them yourself).
1099: This form is for various other types of income you have received in addition to wages. If you have a savings account and you earn interest throughout the year, you’ll receive form 1099-INT. If you earn dividends from investments, you should receive form 1099-DIV. A retirement account will send you form 1099-R, etc. Each form is used to help you complete form 1040 and supporting schedules. The best way to figure out what to do with each 1099 is to look it up on the searchable IRS website forms and publications list. The instructions to each type of 1099 (and other forms) describe how they are to be used.
1098: Mortgage interest you have paid on your home. This is generally deductible if it’s your principle residence and you meet certain eligibility requirements, as are property taxes paid.
1098-E: Student Loan Interest Statement – If you’re paying interest on student loans and you meet certain eligibility requirements (again, those instructions come in handy) you can deduct that interest “for AGI” or “above the line,” which means the deduction makes your Adjusted Gross Income (AGI) smaller. That’s good because your AGI is used to determine your eligibility and amounts for other deductions, credits, etc. So the lower your AGI, the better.
1098-T: Another “for AGI” (“above the line”) deduction (your AGI is the last line on page one of form 1040) is Tuition and Fees paid for qualified education costs. You’ll want to fill out form 8917 and compare it to what you might receive for Education Tax Credits instead (since you can only use one person’s tuition and fees for one or the other).
There are plenty of other forms you might receive, but those are the ones I see most often.
What else should you know?
Filing Status: This can make or break your return, and if you file as something you’re not, your return is next to useless because of the very different rules, credits, exemptions, etc. that are determined by filing status. There are specific requirements for choosing your filing status, so you can’t just choose what sounds good. You should find the specific requirements for each filing status, and if you do have a choice, choose the one that is best for you. The IRS has a good little teaching module here.
Dependents: The rules for claiming dependents are pretty complex, and very important because the tax breaks can be considerable. One of the big things to watch out for is not claiming a dependent that someone else is already claiming. Related is the question of whether or not you claim your children as dependents, or they claim their own exemption. You may want to review dependents at the IRS tutorial website if you’re unsure of how it works.
Exemptions: This goes along with dependents. Each individual gets an exemption. If you’re married filing jointly, you get two exemptions. If you’re single, you get one. If someone else claims you as a dependent, you get no exemption because the person claiming you gets your exemption. Just like you get exemptions for your dependents.
Standard Deduction vs. Itemized Deduction: You have to choose whether to take a standard deduction, which is a set amount based on your filing status, or to itemize your own deductions. The key here is to know what you are allowed to itemize as deductions. The IRS has a handy little list you can check out here, with convenient links that tell you more about each thing.
Tax Credits: The government likes to use the tax system to promote not only its own revenues, but also its agendas. That’s what deductions are all about. Deducting mortgage interest is allowed because home ownership is encouraged by the government. Same for charitable donations. Tax credits are another tool the government uses to either create incentives for certain actions or lifestyles, or to relieve the tax burden of certain taxpayer situations. See another handy IRS list with links here. I see people get these credits regularly, especially lower income tax brackets.
Extra Tax Facts
Some people believe that if you make more money and jump to a higher tax bracket, your entire salary is taxed at that higher rate. That’s not the case. For each level, your salary is only taxed at the rate for that level. For example, the first $8,350 of a single person’s income is only taxed at 10%. If that person makes $33,950 (the upper limit of the 15% tax bracket), the first $8,350 is taxed at 10% and the remainder up to $33,950 is taxed at 15%.
If you win a car on The Price is Right, that is considered by the IRS as taxable income. If you barter services with a neighbor, you are supposed to report the value of what you received for your service on form 1040 as income. For example, if a landlord forgives your $500 rent payment for a month in exchange for you babysitting her granddaughter several full days, you are supposed to report the amount you would have had to pay in rent as income. The landlord would have to report $500 as income also because the fair market value of the babysitting was apparently worth $500 to her, or she wouldn’t have forgiven the entire amount.
That’s enough for now. Let me know if I missed anything that should have been included. Good luck doing preparing your taxes!