I’d like to make a shout out to my fiance, Cameron, who wrote this. He is a tax professional who is working for an accounting firm and who is often the source of explanations for family and friends. Here are some insights on the annual ritual of filing your taxes in the U.S..
“…[I]n this world nothing can be said to be certain, except death and taxes.”
Benjamin Franklin, in a letter to Jean-Baptiste Le Roy, 1789
For most people in the U.S., filing taxes is a simple matter of putting a bunch of numbers into tax software, finding out they get some money back, and not giving it a second thought. This post explains the basics of the US federal income tax system in simple terms as it applies to most people and lists a few FAQs about taxes. A common tax colloquialism in response to how a specific item is treated for tax purposes is “it depends.”
DISCLAIMER: Please understand that this is a general guide and not step-by-step instructions on how to file one’s taxes.
For detailed tax questions you should see a tax professional.
Do I need to file taxes?
You must file a federal tax return if you owe federal income taxes, and you should file if you had taxes withheld (since you might get some or all of them refunded).
The IRS prints in the Form 1040 instructions booklet Charts A-C that detail the conditions that create a tax filing requirement. Chart A is for most taxpayers. Chart B is for dependents. Chart C lists some other special cases.
If you don’t have a tax filing requirement, but federal income tax was withheld from your paychecks because you did not claim “exempt” from withholding, then you should file taxes (even though you don’t owe anything) to get the withholding back as a refund.
If you were paid without any taxes taken out, e.g. in cash or otherwise as a so-called 1099 employee, you need to file and pay taxes if you made at least $400. These “self-employment” taxes are more complicated, so be prepared to learn about how those work.
To file your taxes there are a few different options. You can pay someone to do it for you (probably $100+), you can do it yourself using the paper forms (I do not recommend doing this), you can use an online site, or you can download tax prep software. Some of these options can be free, especially if you have only typical income levels and “tax situations”, e.g. no dependents, and only W-2 income. You will need your W-2/1099 and it should not take more than an hour to complete. Good luck!
(This covers only federal taxes. If you are in one of the 43* states with a state income tax, you will also need to look into those. That’s every state except Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming.)
*Note that Tennessee currently has taxes on investment income, but not employment income.)
Deductions
Deductions reduce the amount of income that is subject to tax: they reduce your taxable income. Deductions fall into three major categories: the standard deduction, itemized deductions, and “above the line” deductions.
– The standard deduction is $12,200 for single filers ($24,400 for married filing jointly). If you claim the standard deduction, this is what you’d put in line 40 of Form 1040.
– If you want to claim itemized deductions instead of the standard deduction, you need to include Schedule A with your tax filing. The total of your itemized deductions goes in line 40 of the 1040 form. The major itemized deductions are for home mortgage interest, state/local/property taxes, and charitable donations. Unfortunately, some of these items were capped in recent tax reform and may limit the amount of itemized deductions you are entitled to.
– “Above the line” deductions are listed in lines 23-35 of the 1040. Most require additional documentation to show eligibility. Commonly used deductions in this category include the student loan interest deduction (line 33), the IRA deduction (line 32), and the self-employment tax deduction (line 27).
One of the most common tax questions asked is “Should I itemize or just take the standard deduction?” If the sum of your itemized deductions is not larger than the standard deduction, you’re almost always better off claiming the standard deduction.
Your state may offer its own tax deductions for state taxes. Details vary by state, but one of the most valuable is the deduction for 529 plan contributions if your state offers it.
Exemptions
Recent tax reform has eliminated personal exemptions and dependency exemptions. The tax reform increased the standard deduction and the amounts of some tax credits.
Taxable Income and Tax Brackets
The biggest point of confusion for a tax novice is how the tax brackets affect tax burden.
The marginal tax brackets can help you plan for 2019. I will use the single filing brackets for illustrative purposes.
Say you’re a single filer that has $48,000 in income. Let’s see how the tax brackets determine the total tax.
You can think of your income as occurring in various bits, and each bit will be taxed at a different rate. Those amounts of tax add up to your total tax.
$12,200 standard deduction at 0% = $0 tax
$9,700 at 10% = $970 tax
$26,100 at 12% = $3,132 tax
Total tax = $4,102
Your “taxable income” is $48,000 – $12,200 = $35,800 in the above example.
You might think of your “effective” tax rate as $4,102 / $48,000 (about 8.5%).
Marginal Tax Rates
Your marginal tax rate and your effective tax rate are not the same thing. Moving into a higher marginal tax bracket does not mean your entire income is taxed at that rate.
Suppose your boss calls you in and tells you that you’re getting a $5,000 raise, so now your taxable income is $53,000 per year! Great! But this moves you from the 12% tax bracket into the 22% tax bracket. How does this affect your taxes? Are you making more money, but losing out overall because of an increased tax burden? No. Your income tax is not 22% of $53,000!
Since the tax brackets are marginal, only the amount above the 22% bracket threshold ($39,745 taxable income in 2019) is taxed at 22%. Your new tax calculation looks like this:
$12,200 standard deduction at 0% = $0 tax
$9,700 at 10% = $970 tax
$29,775 at 12% = $3,573 tax
$1,325 at 22% = $292 tax
Total tax = $4,835
Essentially, $3,675 of your raise was taxed at 12% (adding $441 to tax) to fill up the 12% bracket, and $1,325 of your raise was taxed at 22% (adding $292 to tax).
Note that your “taxable income” is $53,000 – $12,200 = $40,800 in the above example, divided into bits of 9,700 + 29,775 + 1,325.
What’s important to see is that you are still taking home more money. Changing tax brackets did not result in you taking home less income.
To confirm this, look at your “after-tax” income in each case:
Before raise: $48,000 income – $4,102 tax = $43,898 after-tax
After raise: $53,000 income – $4,835 tax = $48,165 after-tax
Your “effective” tax rate is now $4,835 / $53,000 (about 9.1%).
Tax Withholding
Your employer is required to withhold taxes from each of your paychecks by law. The formulas for withholding can be found in IRS publication 15. You can adjust your withholding by giving a new modified W-4 form to your employer. The W-4 allows you to specify the number of allowances or extra withholding from your paycheck.
The IRS also provides a withholding calculator that can help you determine if you are withholding too much or too little from your paychecks. The calculator is especially useful if you have more than one W-2 (such as you have multiple jobs or you’re married and both spouses work) or if your job situation changes midyear.
Sometimes it’s hard to understand how the “allowances” you put on your W-4 are related to the amount of withholding that will occur. One way to think about this is as follows. If you’re single, the withholding algorithm will treat this amount of your income as not taxed:
not taxed (single) = $3,900 + $4,150 * (number of allowances)
If you’re a single taxpayer, your $12,200 standard deduction means that $12,200 of your income is not taxed. That is why using “2” allowances on your W-4 line 5 would be appropriate, as that conveys to the withholding algorithm to consider exactly $3,900 + $4,150 * 2 = $12,200 of your income as not taxed.
Similarly, if you’re married but do not have any dependents, the withholding algorithm will treat this amount of your income as not taxed:
not taxed (married) = $11,950 + $4,150 * (number of allowances)
Since when you’re married you get a $24,400 standard deduction, using “3” allowances on your W-4 line 5 is appropriate, as that causes the withholding algorithm to consider $11,550 + $4,150 * 3 = $24,400 of your income as not taxed.
Tax Credits
Tax credits directly reduce your tax burden by effectively giving you a refund. There are dozens of tax credits in the tax code. Some of the more common, subject to eligibility, are the Earned Income Tax Credit, the Child Tax Credit, the Child and Dependent Care credit, Foreign Tax Credit, American Opportunity Tax Credit, and Lifetime Learning Credit. Your state may offer tax credits as well.
If you have a child that is going to make you eligible for child tax credit, you can achieve accurate withholding by adding other allowances, the number required being related to your tax bracket. See the instructions for Form W-4. Quick tip: Since the child tax credit is worth $2000, if you’re in the 10% or 12% bracket, use 4 extra allowances per child; if you’re in the 22% or 24% bracket, use 2 extra allowances per child. This forces less withholding to occur such that the amount less is close to the value of the tax credit. If you don’t adjust your allowances that way, then the tax credit would come to you as a refund after you file.
Tax “Refunds” — Not Ideal
Your tax filing calculates your actual tax obligation to what you’ve had withheld throughout the year. If you under-withhold, you will owe the IRS the difference. Beware that if you purposely under-withhold too much, you may face a penalty.
If your tax obligation is less than what you’ve had withheld throughout the year, the difference is returned to you as a “tax refund.” While it may seem counterintuitive, tax refunds are not a good thing. “Refund” implies that you actually owed the money you paid at some point – this is not the case. Money that you never owed was being held by the government at 0% interest. Instead of working for you throughout the year by paying down debt or funding your retirement accounts, your money was effectively doing nothing for anyone. Aiming for as small a refund as possible, or even owing a small amount, is highly advisable. You can do so by adjusting your allowances on your W-4.
Capital Gains and Capital Losses
Tax rates for capital gains are different than ordinary income tax rates, and the rates apply progressively so that it’s some capital gains are taxed at 0% , some are taxed at 15%, and the rest (above $434,551) are taxed at 20%. The dividing point between 0% and 15% rate changed because of tax reform and does not quite match the line between the 12% and 22% bracket, but it’s very close.
Other Taxes
Several other taxes you will or may be responsible for paying, and will see withheld from your paycheck:
– State/local taxes – rates vary by state and locality.
– Old Age, Survivors, and Disability Insurance – 6.20% on up to a certain amount of taxable income.
– Medicare – 1.45% on your entire taxable income. If you are a high earner you may have to pay an additional 0.9%.
Frequently Asked Questions about Taxes
Should I see someone about my taxes?
Even if you’re itemizing your deductions, the majority of people that ask this question are likely capable of filing their taxes themselves. Tax situations that may merit seeing a professional would be a small business, multiple state residencies/income, or overseas tax issues (foreign tax credit, foreign earned income exclusion). Tax preparation costs vary based on complexity and where you live, but most tax returns can be prepared by a professional for a few hundred dollars.
What tax software should I use?
The highest rated tax software options are as follows:
– TurboTax
– Credit Karma Tax
– TaxACT
– FreeTaxUSA
Companies generally charge more for more complex tax filings with capital gains, rental income, state income taxes, etc.
If you meet certain conditions you can file your federal return for free using commercial software through the IRS Free File site. Since vendors can add additional income and form restrictions, see the IRS Free File Software Offers to check for limitations. Commercial sites have been offering competing free federal versions, but only programs accessed through the IRS Free File portal are guaranteed to be free. The IRS has announced recent changes to the program standards to reinforce this.
If you do not meet the software conditions, you can still use Free File Fillable Forms for a free federal e-file.
What tax preparation assistance programs are there?
Read the Free Tax Return Preparation for Qualifying Taxpayers page on the IRS website. In particular, it highlights these two programs:
1) The Volunteer Income Tax Assistance (VITA) program offers free tax help to people who generally make $56,000 or less, persons with disabilities and limited English speaking taxpayers who need assistance in preparing their own tax returns. IRS-certified volunteers provide free basic income tax return preparation with electronic filing to qualified individuals.
2) In addition to VITA, the Tax Counseling for the Elderly (TCE) program offers free tax help for all taxpayers, particularly those who are 60 years of age and older, specializing in questions about pensions and retirement-related issues unique to seniors. The IRS-certified volunteers who provide tax counseling are often retired individuals associated with non-profit organizations that receive grants from the IRS.
I already filed my taxes. Can I still contribute to a Roth IRA?
Yes. Unless you’re eligible for the saver’s credit then your Roth contribution after you file your return but before the April 15 deadline will not affect your tax filing. Roth contributions are post-tax.
Why doesn’t the student loan interest deduction double for couples married filing jointly?
That’s just the way the tax code was written. The maximum you can deduct in student loan interest is $2,500 regardless of your filing status.
What’s the difference between a tax deduction and a tax credit?
Tax deductions reduce the amount of your income that is taxed, while tax credits reduce your tax burden directly. The amount your tax burden is reduced by a deduction is the amount of the deduction times your marginal tax rate. For example, a tax deduction of $1,000 for someone in the 22% tax bracket will save $220 on their overall tax burden. A tax credit of $1,000 will save $1,000 on their overall tax burden.
Can I claim so-and-so as a dependent?
Use this handy flow chart, fill out the IRS’s handy tool, or refer directly to IRS publication 501.
I screwed up a tax return for a previous tax year. What should I do?
You need to file an amended return, form 1040X. The IRS provides this guidance for filing amended returns. As the IRS notes, your state tax obligation may change based on your federal tax obligation. You may need to file an amended state return as well.
I didn’t file my taxes on time this year, but I’m owed a refund. What should I do?
There’s no penalty for filing late if you’re owed a refund. File normally. (Don’t file a 1040X.) You have 3 years to file to get your refund.
*If you enjoyed any part of this post, please consider liking it. If you loved it, please consider following me on WordPress. I also love comments including questions, advice, or a review of the post itself. Thank you for reading and best of luck in your adventures.*
Please feel free to comment with any questions and I will see if Cameron or one of his coworkers has an answer.
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