By Tina Wood-Wentz
What are income taxes?
Income taxes are money the government collects based on what you’ve earned. This is one of the primary methods the United States government uses to pay for its undertakings, everything from defense to schools to road repairs are funded by income taxes. In some countries, income taxes are simple and handled almost exclusively behind the scenes. In the United States, our tax code is more complex, and individuals benefit from being more educated on its intricacies.
What is the difference between subtractions, deductions, and credits?
Deductions are fancy words for subtractions, they’re equivalent. They are dollars that you won’t pay taxes on. Credits are tax dollars that you don’t have to pay. Therefore, if you are offered a $1000 subtraction, or a $1000 credit, you want the credit, it’s much more valuable (the $1000 subtraction is probably worth a credit of ~$200, depending on your tax bracket).
How is the income tax return structured?
My favorite tool for looking at the structure of the federal income tax return is the 2017 Form 1040. That’s because this is the last year the federal form was laid out with all of the big players on one sheet of paper, and with the sections so clearly demarcated. If you are a visual learner, this is the tool I recommend. However, be aware that tax law is a constantly changing beast. Between the Tax Cuts and Jobs Act of December 2017, the SECURE Act of 2019, the CARES Act of 2020, the Consolidated Appropriations Act of 2020, and the American Rescue Plan Act of March 2021, we’ve had five major tax law changes in 3 1/2 years.
The federal personal tax return, Form 1040, begins with a demographics section, and is all about who the tax return covers. The second section, beginning on Line 1, is about ways you earned income. The third section is about subtracting income that you won’t be required to pay taxes on, as subtraction “adjustments” or deductions. The fourth section is about credits, directly reducing your total tax bill. The fifth section is calculating how much you’ve paid in so far (along with a few more credits). The sixth section is just figuring out how much who owes whom – do you owe the IRS, or do they owe you – and how that money will change hands. And finally, the seventh section is signing off verifying that the tax return was completed honestly. The math required is elementary school level – addition, subtraction, multiplication, and division.
Because the United States tax code and its clarifications are giant, with thousands of pages of intricacies, collecting and calculating the numbers can’t all be boiled down to a two-page document. That’s where forms and schedules come in. Forms and schedules are only added to the 1040 when they are relevant to your own personal situation. If you own rental real estate, then Schedule E should be included in your return, but if you don’t then that’s a paperwork rabbit hole you don’t need to go down. If you are going to itemize instead of using the standard deduction because you’ve got a lot of property taxes and home mortgage interest and medical expenses and gifts to charity, then you include a Schedule A in your tax return; if you don’t have those items this year, then you don’t include Schedule A.
What are common factors that impact my taxes?
Different life stages of course have different factors that more commonly impact a tax return. It’s important to know what will have an impact in other life stages, so you can be on the lookout for upcoming changes and remember to save your receipts/documentation. If you don’t, you can miss substantial tax savings when your situation changes.
Congratulations, you’ve earned income! And, your tax return is likely at its least complicated point in your whole life. Therefore, now is the time to compare your situation to what is documented in your tax return. And then, as your financial life slowly gets more complicated, or tax laws change, you only have to add one piece of knowledge to your tool kit at a time.
If your family has college funding under control, or college isn’t in your plans, look into contributing to an IRA for the first time.
You now get to claim your own standard deduction that’s not at a reduced rate.
You may have student loans you are paying off. Those are partially deductible.
If you are a teacher, there’s a deduction for school supplies you’re buying out of pocket.
Those unfortunate enough to have high medical or dental expenses may be eligible for a deduction.
If you bought a house or made energy-efficient improvements to a house, you may be eligible for a deduction.
Gifts to charity or losses from federally declared disasters may be eligible for a deduction.
Not on your income tax form directly, but with a definite impact, you may be able to reduce your taxable income through a health care flexible spending account, health savings account, and/or a 401(k), 403(b), 457(b).
If you run your own business, there’s an entire form for sole proprietors, one for owning rental real estate, and one for owning a farm. These allow you to deduct your expenses from your gross income, so you only pay taxes on your net income. And there’s also a qualified business income deduction.
Parents of younger kids
Look into the Child Tax Credit, the Additional Child Tax Credit, the Earned Income Tax Credit, and the credit for child/dependent care expenses.
Your state may have deductions or credits for 529 college funding plan contributions and private or additional schooling expenses. They may also still have exemptions for dependents.
Not on your income tax form directly, but you may be able to reduce your taxable income through your employer through a dependent care flexible spending account. Often this election needs to be made at open enrollment time.
As your kids go to college, look into the American Opportunity Tax Credit or the Lifetime Learning Credit.
There aren’t any income tax benefits that you’ll see as new line items on your tax return, but beginning at age 50 your income tax return can still be impacted by reducing your taxable income via traditional contributions in the additional catch-up space of your IRA, 401(k), 403(b), 457(b) (governmental only).
Your Social Security may not be taxable at the same rates as the income you’ve been used to earning. And depending on your state, it may not be subject to state income taxes at all (while 42 states have income taxes, only 19 tax Social Security).
Your pensions, along with distributions from your IRAs, 4019(k)s, 403(b)s, and 457(b)s are taxable income.
Your standard deduction increases.
And through your state, but not directly on your income tax return, you may have reduced property taxes. If you work with a tax preparer for your income taxes, they may help you prepare a property tax refund return.
When are income taxes due?
The United States has a pay-as-you-go system. So technically income taxes are due as you earn them, and if you wait until what we think of as tax time in Q1 to pay, you will owe penalties for that delayed payment.
However, the reconciliation paperwork that’s called your income tax return (what most of us think of as “when it’s due”) is usually due in mid-April, for income earned the calendar year prior. In 2021, as the result of all the tax implications of COVID-19, the 2020 return deadline was extended to May 17th, 2021. The extension deadline for 2020 remains its usual mid-October date (October 15th), and if you want to utilize the extension deadline you need to file Form 4868 – but beware, an extension of time to file paperwork is not an extension of time to pay. You can find an extensive list of tax deadlines in IRS tax publication 509.
What if I can’t afford to pay my taxes due?
If you can’t pay now, don’t let that scare you into failing to file your tax return – the IRS is even more interested in the paperwork being filed than they are about collecting the money immediately. If you find at tax time that you can’t pay the total due, you can get into an installment payment plan with the IRS.
For many people, since our income taxes are progressive (that means those that earn less money, pay less taxes), the problem isn’t the sheer dollars of the income taxes, the problem is planning cash flow. You can increase your future withholding of income taxes through your employer using a form W4, and you can estimate how much should be withheld using the IRS tax withholding estimator tool so that you don’t encounter this problem in the future.
What if my tax return is wrong?
If upon reviewing your own tax return, you discover an error, it’s good to be proactive and show the IRS you were operating in good faith by filing a correction. The correction is a separate document, an amendment, Form 1040-X. Do NOT file a second Form 1040, that will only confuse the IRS at best, and be ignored at worst.
What if I get a letter or phone call from the IRS?
First, if you get a phone call that claims to be from the IRS, it’s a scam. You can call them, but they won’t call you out of the blue. Instead, the IRS sends letters and rarely calls, but if they call it will only be after you’ve received a letter telling you to expect a call.
If you get a letter from the IRS, it should spell out what the IRS sees as the problem, along with their desired solution. However, currently, the IRS is very backlogged, which can be scary as you may get increasingly threatening automated letters when you’ve already done your best to address the problem – but the forms you’ve submitted in response haven’t been processed yet due to the backlog. Think of it as a very bad “they crossed in the mail” type of problem, and take a deep breath. You may wish to involve a tax professional, for your peace of mind and to reassure yourself that you’re addressing the problem correctly.
What about state income taxes?
Not all states charge income taxes. Some acquire their operating budget other ways, such as through higher sales and/or property taxes. As of this writing, eight do not charge state-level income taxes. Each state’s income tax laws are different, and they don’t have to be aligned (called “conformant”) with the federal income tax rules.
Some municipalities or localities also charge income taxes, this is common in Ohio and Michigan. Separate returns are due to each entity to whom you owe taxes, and each has its own forms. But in general, state income taxes are going to consider a lot of the same factors your federal income tax return considers, plus possibly a few more - such as those that benefit parents (529 plan contributions to fund college, and additional schooling expenses are common ones).
Your income tax return doesn’t have to be an incomprehensible document and preparing it doesn’t have to be overwhelming or scary. Look through yours to see if your income tax components you know about have been properly captured and look to see what other non-zero line items and forms are included – determine what new-to-you information can be learned that impact your tax return. Do you know of any upcoming situation changes you can now plan for, so you keep the right documentation for completing your next tax return in 2022?
About the author: Tina Wood-Wentz, MS
Tina Wood-Wentz wants to help you feel comfortable understanding your financial situation, and using your money as a tool for feeling more secure about your life. She is a financial educator, paraplanner, and founder of Wood Financial Services LLC. With an extensive background that includes whitewater kayak instructor, data scientist, tax preparer, and board member for many non-profits, Tina brings a passion for understanding numbers along with helping and educating others.
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