Athletes like to say “no pain, no gain,” and that’s the truth for many taxpayers, too.
Unless you go through the trouble of learning about important provisions of the nation’s complex tax code, you may pay higher taxes than necessary.
And even if you pay someone to do this for you, it’s probably wise to understand some of the essentials of tax preparation. One of the least painful ways to get started is to take a walk through a Form 1040.
To help people understand the process and map their own opportunities, the following sample return for a hypothetical couple was prepared in consultation with Bob Meighan, a vice president at TurboTax, the tax software published by Intuit.
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The hypothetical family includes two working parents, Samuel and Felicity, two children and Samuel’s father, Sydney, who lives with them. His unreimbursed medical bills, which they paid, and education credits for their son, Cyril, a college student, gave them tax breaks, as did deductions for a home mortgage and state income taxes.
The software uses interview questions, then fills out the forms and does the calculations. TurboTax can also download many W-2 and 1099 forms that report income.
Form 1040 starts with a summary of income. Then come various adjustments, deductions and personal exemptions, all of which lower income and are used to calculate how much income is taxable. Most of the numbers are bottom-line figures from supplemental forms and schedules or work sheets.
Taxable income and the tax on it, along with any credits, refund or payment due, are calculated on Page 2.
The Internal Revenue Service encourages taxpayers to file electronically, which saves collating papers and speeds refunds, and e-filing is included with TurboTax and some other programs. Individual taxpayers may still mail in paper forms, however. Either way, the preparation is the same.
The most tedious part may be collecting all the information related to your income and deductions. Employers, banks, brokerage firms and others who made payments to you must report these payments on W-2 and 1099 forms and send copies to you and to the IRS. It compares returns filed with what the payers have reported, so don’t guess at a number for a missing W-2 or 1099.
In this example, Samuel P. and Felicity Q. Taxpayer, like most married couples, are filing jointly (Line 2). They claim five exemptions (Line 6) — two for themselves and one each for their children, Cyril, 19, and Heidi, 15, and Samuel’s father, Sydney.
Step 2 Reporting income
Next, the couple’s income is reported.
Felicity, a designer, reports a salary of $81,000 on Line 7 of the return. Actually, she earned $90,000, but elected to have $9,000 of it go into an employer-sponsored tax-deferred 401(k) retirement account. That contribution shows up on her W-2 form, but not on their tax return.
Samuel is a self-employed consulting engineer. His net income of $92,791 — after office rent and other expenses — is brought forward from Schedule C to Line 12.
Taxable interest income of $526 is reported on Line 8a. Their ordinary dividends of $719 on Line 9a are all qualified (Line 9b). Because they did not have more than $1,500 of either interest or dividends, they did not have to file Schedule B.
Long-term capital gains, as well as qualified dividends, which include most dividends from domestic stocks and stock-based mutual funds, are still taxed at 15 percent for most taxpayers, but for top-bracket taxpayers the rate is now 20 percent. People in the 10 and 15 percent income-tax brackets aren’t taxed on qualified dividends or capital gains, but still must report them. These numbers come from the year-end tax statements on Form 1099-DIV issued by financial institutions.
Capital gains of $5,340 (Line 13) come from Schedule D. As the stock market rose last year, the couple sold three holdings, recognized some gains and moved into other shares that they hope will be strong performers.
Their total income is $180,376 (Line 22).
Above the line deductions
Next come two adjustments, often called above-the-line deductions. Both employers and employees, through withholding, contribute to Social Security and Medicare, and employers can deduct the contributions they make. So self-employed people, who pay both portions, are allowed to deduct the employer’s share.
Samuel’s deduction is $6,556 (Line 27). On Line 28 is $17,247 for his self-employed pension plan. Employed people who do sideline consulting or freelance work may also take similar deductions, or adjustments. The couple’s adjusted gross income, $156,573, is on both Lines 37 and 38. Adjusted gross income is important because it affects many other numbers; it limits some deductions and credits and is often the starting point for state returns.
Credits and the bottom line
After itemized deductions of $36,938 (Line 40, from Schedule A) and five personal exemptions worth $19,500 (Line 42), the couple’s taxable income is $100,135 (Line 43). The regular tax on that is $16,285 (Line 44).
An enormous complication in the tax code is that taxpayers are expected to calculate their regular tax, then calculate the alternative minimum tax — which denies personal exemptions and certain other tax breaks, notably the deduction for state and local taxes — and pay whichever is higher. Line 45 is blank on this return because TurboTax performed the dual calculations and found that the Taxpayers were not liable for the AMT.
Next are credits, which reduce taxes dollar-for-dollar. That makes credits much more valuable than deductions, which reduce taxes only at a taxpayer’s marginal rate, 25 percent for this couple. The Taxpayers claim credits of $1,500 (Line 49) and $1,000 (Line 66), both from Schedule 8863 for Cyril’s college costs.
Self-employment tax of $13,111 (Line 56) comes from Schedule SE. Taxes of $10,500 were withheld from Felicity’s salary (Line 62). Samuel, being self-employed, wasn’t subject to withholding, so they paid quarterly estimated taxes of $16,000 (Line 63) to cover his earnings and their other income — interest, dividends and capital gains.
The bottom line is that they owe $396 (Line 76). Many people would be disappointed not to get a refund. Others would be pleased: They calculated their estimated payments carefully and didn’t give the Treasury an interest-free loan.