Federal tax laws are so complicated that most people outsource tax preparation and have little understanding of how it all works. Do you know how your taxes are calculated? Or the difference between a credit and a deduction? It’s your hard-earned money and your government, so you really should.

 

It’s that time of year again. March. Daffodils and taxes. Ah, taxes. That convoluted, expensive, intimidating annual reminder of our duty to US society. Once you look into it, you realize that there aren’t many things more complicated in life than our US tax system. So complicated, in fact, that an entire industry exists just to help people file their tax returns. 

 

When you hear politicians bragging about creating jobs, they really just mean that they’ve made things so complex that the average American is afraid to do their own taxes. Only 8.5% of the people that GOBankingRates.com surveyed last year use the IRS forms to calculate their taxes themselves. Everyone else is so intimidated by the intricacies of the tax law that they hire a tax preparer or use custom software.

 

What about you, what do you do? If you outsource your tax preparation, do you even know how they arrive at that final number? Have you ever dared to look beyond the line that tells your refund or the amount you owe? Most people haven’t.

 

How Taxes Are Calculated

Even if you never plan to prepare your own taxes, you should have a basic understanding of how things work. For example, how are taxes are calculated? It’s not as simple as looking at your income and comparing it to a tax table. That would put H&R Block out of business. This is how federal income taxes are calculated:

 

1. First, you calculate your Income. This consists of:

• Wages listed on your W-2
• Interest from bank accounts
• Dividends received
• Alimony received
• Self-employment income
• Rental income
• Royalties received
• IRA distributions
• Pensions and annuities
• Social Security benefits
• unemployment compensation

 

2. Second, you have a chance to lower your income before calculating taxes. Here you can deduct:

• HSA contributions
• Educator expenses
• Moving expenses
• Alimony paid
• IRA contributions
• Student loan interest paid
• Some tuition and fees
• Part of your self-employment tax

 

These are called “above the line” deductions. When subtracted from the income you calculated in step one, you are left with your Adjusted Gross Income (AGI).

 

Income

– Above The Line Deductions

= Adjusted Gross Income

 

3. Next, you subtract Deductions and Exemptions (as explained below) to arrive at your Taxable Income.

 

Adjusted Gross Income

– Deductions

– Exemptions

= Taxable Income

 

4. This is the point at which you go to the tax tables and figure your Tax, based on your taxable income.

 

5. Now you subtract any Nonrefundable Credits to lower the amount of income tax that you owe.

 

6. To that amount you add additional taxes, such as self-employment taxes and the Obamacare shared responsibility payment.

 

7. Finally, you have one last chance to lower your tax payment with Refundable Credits. After those are subtracted, you compare the number left, your Total Tax, with the amount of taxes withheld on your W-2. If your employer withheld more than you owe, you get a refund. If they withheld less, you owe.

 

Tax

– Nonrefundable Credits

+ Additional Taxes

– Refundable Credits

= Total Tax

Total Tax < Taxes Withheld = You Get A Refund

Total Tax > Taxes Withheld = You Owe More

 

Simple, right? Not really. That’s why it’s revolutionary that the House Republicans want to make it so that almost anyone could file their taxes on a postcard. That would be a feat! Here is a little more detail on some of the things mentioned above:

 

Deductions (Step #3)

Your deductions lower your taxable income. You can choose to take either the Standard Deduction or itemize your deductions. It’s usually better to choose whichever is greater. For 2016, the Standard Deduction for married couples is $12,600 and for singles is $6,300.

 

To itemize deductions, you have to fill out a separate form and you can include:

• Medical and dental expenses over 10% of your AGI
• State and local income taxes or sales taxes
• Real estate taxes
• Home mortgage interest
• Mortgage insurance premiums
• Gifts made to charity
• Casualty and theft losses
• Unreimbursed employee expenses
• Tax preparation fees

 

Exemptions (Step #3)

An exemption is basically an amount you get to subtract from your AGI for each person in your household. Most people can claim an exemption for themselves, their spouse, and their dependent children. For 2016, the exemption amount is $4,050 per person.

 

Credits

Whereas deductions and exemptions lower your taxable income, credits lower the actual amount of taxes you owe. For example, if you are in the 25% tax bracket, a $100 deduction or exemption would lower your tax bill by $25. A $100 credit would lower your tax bill by $100. Therefore, credits are worth more in the end than deductions and exemptions.

 

Nonrefundable (Step #5)

Some credits are nonrefundable. This means that you can subtract them from your tax bill, but once you hit $0 the credit can no longer be applied. They cannot lower your self-employment tax or Obamacare penalty. Some nonrefundable credits are:

• Foreign tax credit
• Child and dependent care credit
• Education credits
• Adoption tax credit
• Retirement savings contributions credit
• Child tax credit
• Residential energy credits

 

Refundable (Step #7)

Some credits are refundable, meaning that if the credit is greater than the amount of taxes you owe, the government will actually pay you money. This is why it is recommended to file a tax return even if you don’t owe any money- you could receive money instead. Some refundable credits are:

• Earned income credit
• Additional child tax credit
• American opportunity credit (only partially refundable)
• Health coverage tax credit

 

 

So there you have it. That’s how your federal income taxes are calculated and what the different terms mean. I hope I’ve taught you something and not just scared you. A big chunk of your hard-earned money is going to the government, and I think it’s important that you understand how they decide how much to take. It’s your money, it’s your government, it’s your responsibility.