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.
What is total or gross Income? [Line 22]
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:
If you’re a parent, your child’s taxable income is inherently linked to yours. Get information for filing for a dependent and learn about the kiddie tax
How to calculate your adjusted gross income [Line 37]
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
Your AGI also determines your eligibility for certain other deductions and credits. For example, you are eligible to contribute to a Roth IRA
for 2011 only if your AGI is under $122,000 for single filers and under $179,000 if you're married filing jointly.
Choosing standard or itemized deductions [Line 40]
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 2011 is $5,800 for single filers, $11,600 for married filing jointly and $8,500 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
Keep in mind that you can’t deduct political contributions, credit card interest or interest on a personal car loan.
How many personal exemptions you can claim? [Line 6d]
A personal exemption is an amount you can subtract from your AGI that is determined by the government and indexed annually for inflation. For 2011, the personal exemption is $3,700.
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?
A child is qualified based on age, relationship to you, residency and means of support. Another relative can be qualified based on the relationship to you, the relative’s gross income and the amount of support that you supply. For more details, go to IRS.gov
A simple formula for determining taxable income [Line 43]
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:
You can use this number to calculate your tax due. See detailed tax tables (PDF).
What’s your tax rate?
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.
For example, if you are single and your taxable income is $40,000, your marginal income tax rate is 25 percent, but your average tax rate is likely quite a bit lower.
Your combined tax rate and your investment return
There’s one more tax rate you need to consider: your combined tax rate. This includes your state income tax rate plus your federal income tax rate. So, if you pay 20 percent in federal taxes and 5 percent in state taxes, your combined rate is 25 percent. This number is especially important when calculating your return on an investment. Because if an investment earns 8 percent, and your combined tax rate is 25 percent, your rate of return is really 6 percent.
Making use of tax credits [Lines 47–54]
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. Learn more at IRS.gov.
A frequently overlooked credit
Some low-income working individuals and families will qualify for the
Earned Income Tax Credit.
This valuable benefit provides an actual refund,
not just a credit against taxes due. You can find out if you qualify by visiting IRS.gov
How to arrive at your tax due [Line 75 or 76]
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 56]
- 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 57–61]
- Subtract any payments you’ve already made, such as taxes that have been withheld from your paycheck and reported on your W-2. [Line 71]
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.
File on time! You can get an extension—but you will be charged interest on any amount that is not paid by April 15. There’s also a penalty for late filing.
Payroll taxes 101
FICA, which stands for Federal Insurance Contributions Act, consists of both Social Security (OASDI) and Medicare taxes. Typically, the employer and employee split the cost equally, but the Tax Relief Act of 2011 reduced the employee share. As a result of this legislation, FICA taxes are as follows:
- Social Security: Employee pays 4.2 percent of the first $110,100; employer pays 6.2 percent
- Medicare: Both employee and employer pay 1.45 percent on all earnings
This means that under current legislation, if you’re a wage or salaried employee, 5.65 percent of your paycheck will be withheld for the first $110,100 you earn. After that, an additional 1.45 percent will be withheld for Medicare. Your employer will pay 7.54 percent for the first $110,100, and 1.45 percent after that.
However, when the temporary reduction expires, both employee and employer will pay 6.2 percent for Social Security taxes.
What if you’re self-employed?
If you're self-employed, you pick up the entire tag for FICA taxes—currently 13.3 percent of your net. (Note that you can deduct half of this tax from your gross income when calculating your AGI.) When the tax cut expires, you will pay 15.3 percent.
What records to keep
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.
A word about tax audits
Even though the IRS only has three years to audit your return, they have six years to follow up if you underreport your income by more than 25 percent. Also, if you don’t file a return or file a fraudulent return, there are no time limits on when they can investigate.
The information on this website is for educational purposes only. It is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager.