Calculating Your Taxes
Navigating your 1040
Anyone with income over a certain amount must pay federal income taxes. Most states also impose an income tax, and in some places there are local income taxes as well. As we discussed in Income Taxes, tax rates vary by the amount of income and whether you're a single filer or married filing jointly.
Calculating your taxes and filing your income tax return can sometimes be confusing. This page is intended to help you understand and complete your individual tax return using IRS Form 1040. If your situation is complex, you may want to consult with a tax advisor.
Your total or gross income includes:
- Earned income, which comes from employment and can take the form of wages, salary, tips, commissions and bonuses. Earned income may be subject to both income and payroll taxes.
- Unearned income, which comes from sources other than employment, such as dividends, interest, capital gains or U.S. savings bonds. Most unearned income is subject to income taxes.
Important things to remember
- Other sources of taxable income include alimony, unemployment compensation, gambling winnings or lottery winnings.
- Income that’s not taxable (these are called exclusions) include: a gift or inheritance, child support, life insurance proceeds following the death of the insured, interest from municipal bonds, disability income if you paid the premium with after-tax dollars, and certain employee fringe benefits.
- If you have stocks, bonds or other investment assets in a taxable account, your profit or loss is known as a capital gain or a capital loss. Capital gains are currently taxed at a maximum rate of 15 percent.
Filing Tip for Parents:
Your adjusted gross income (AGI) is an important part of your tax calculation. To get your AGI, you can subtract certain deductions from your income to reduce the amount of income that will be taxed.
Some examples of deductions that help determine your AGI:
- Deductible IRA contributions
- Contributions to a Keogh (self-employed) retirement plan
- Self-employed health insurance deductions
- One-half of self-employment tax
- Alimony paid
- Qualified moving expenses
- Penalty on early withdrawal of savings
- Qualified higher education expenses
- Teacher’s education expenses up to $250 (or $500 for two-teacher couple)
- Qualified student loan interest (up to the allowable limits)
Why your AGI is Important
Once you know your AGI, you have the opportunity to lower your taxable income even more by subtracting either the standard deduction or your itemized deductions—whichever is greater.
When to consider the standard deduction
If your financial situation is straightforward, the standard deduction might be the best and simplest choice. The standard deduction for 2014 is $6,200 for single filers, $12,400 for married filing jointly and $9,100 for head of household.
When to consider itemizing deductions
If you own property, run a business from home, have paid extensive medical bills or manage a lot of investments, you might be better off taking the extra time to itemize your deductions.
Examples of legitimate itemized deductions:
- Property taxes
- State and local income taxes (or state sales taxes if your state does not have an income tax)
- Specified medical and dental expenses that exceed 7.5 percent of your AGI, including limited amount of premiums paid for long-term care policies
- Mortgage interest on first and secondary residences (up to maximum debt of $1 million), plus interest on home equity loans (maximum debt up to $100,000)
- Charitable contributions to tax-exempt organizations
- Casualty and theft losses (see IRS guideline)
- Investment interest expense (e.g., margin interest expense)
- Miscellaneous expenses, including impairment-related expenses for persons with disabilities and gambling losses to the extent of gambling winnings
- In addition, the following can be itemized if the cumulative total is more than 2 percent of your AGI:
- Business expenses not paid by your employer (such as union or professional dues, unreimbursed travel or uniforms)
- Tax-preparation fees
- Investment advisor fees
What you CAN’T deduct
A personal exemption is an amount you can subtract from your AGI that is determined by the government and indexed annually for inflation. For 2014, the personal exemption is $3,950.
You can claim three kinds of personal exemptions:
- For yourself—You’re allowed one exemption for yourself.
- For your spouse—If you’re married and filing a joint return, you’re allowed two exemptions: one for yourself and one for your spouse.
- For your dependents—You’re allowed an exemption for each qualified dependent, which can be a child or other relative.
What’s a qualified dependent?
Once you know your AGI and the deductions and exemptions you qualify for, it’s easy to come up with your taxable income. The formula is:
|A Simple Formula for Determining Taxable Income|
- itemized or standard deductions
- personal exemptions
|= taxable income|
You can use this number to calculate your tax due. See detailed tax tables.
As we saw from the tax rate schedules, you pay a proportionately larger amount of taxes on higher amounts of income. This results in two different tax rates:
- Your marginal tax rate is the percentage of tax you pay on your last dollar of taxable income.
- Your average tax rate is just that—the average amount that you pay taking into consideration all of your income.
Your combined tax rate and your investment return
A tax credit reduces the taxes you owe dollar for dollar. A credit is more valuable than a deduction. A $100 credit means that you pay $100 less in taxes. A deduction simply reduces your taxable income.
There are a number of tax credits available, depending on your income and personal situation. A few examples include:
- Credit for qualified adoption expenses
- Credit for a qualified child under the age of 17
- Child and dependent care credit
- Residential energy credit
- American Opportunity tax credit for qualified expenses for college. Learn more at IRS.gov.
- Lifetime learning credit for expenses related to improving job skills and for pursuing an undergraduate, graduate or professional degree.
A frequently overlooked credit
After you've figured out your taxable income, there are three more steps to arriving at your actual tax due.
- Subtract any credits from your taxes owed. [Line 55]
- Add any other taxes to your balance. Examples include either the self-employment tax or the alternative minimum tax (learn more about the AMT at IRS.gov). [Lines 56-60]
- Subtract any payments you’ve already made, such as taxes that have been withheld from your paycheck and reported on your W-2. [Line 72]
The final number is the amount you owe. If you’ve overpaid, the final number is the amount of your refund.
If you’re getting a big refund, you’re probably having too much withheld from your paycheck. In effect, this means you’re giving the government an interest-free loan. On the other hand, if you have too little withheld, you may be charged an underpayment penalty.
Our Two Cents
FICA, which stands for Federal Insurance Contributions Act, consists of both Social Security (OASDI) and Medicare taxes. The employer and employee split the cost equally as follows:
- Social Security: Employee pays 6.2 percent of the first $117,000; employer also pays 6.2 percent
- Medicare: Both employee and employer pay 1.45 percent on all earnings
This means that if you're a wage or salaried employee, 7.65 percent of your paycheck will be withheld for the first $117,000 you earn. Your employer will also pay 7.6 percent for the first $117,000.
What if you’re self-employed?
Doing your taxes will be a lot easier if you keep the right records—and keep them easily accessible. It’s wise to keep:
- All of your tax returns for seven years. This includes all supporting documents such as forms that show your income and validate your deductions: W-2, 1099s, canceled checks, receipts for charitable contributions, etc.
- All home ownership documents, including records of home improvements. (You’ll need this to calculate your tax basis when you sell your home.)
- Investment records, including what you paid and when you sold.
- Statements for retirement accounts. In particular, you will need to have records of after-tax contributions.