Understanding taxes and your 1040
Taxes. Everyone hates them. Nobody wants to deal with them. Unfortunately, they are an evil necessity in the United States. This time of year brings a lot of thought about taxes and everything involved in making sure you file a proper return. For many, understanding your taxes is even more difficult than dealing with them.
First step to understanding taxes is that income taxes in the United States are based on a progressive tax scale. What that means is that your income is taxed on a sliding scale depending on how much income you make each year. The tax brackets for 2021 are broken down into seven different percentages. Those percentages fall between 10% to 37% federally. For states, it varies from no income tax to 13.3% for the highest earners in California.
Understanding how taxes work is important. You are only taxed at a certain percentage for the dollars you make in that percentage field. This nuance is essential since many people incorrectly believe that all your income is taxed in your specific tax bracket.
For instance, a single filer who has a taxable income (amount of income after deductions) of $50,000.00 only is taxed at the highest rate of 22% federally for the dollars over $40,526.00. The first $9,950.00 of taxable income is taxed at 10% and the income between $9,950.00 and $40,526.00 is taxed at 12%. This would mean the total tax for this example would be $6,748.40. So, when someone says they fall into a certain tax bracket, only a portion of their income is taxed at that top rate. Most states do the same with different percentage of tax depending on the state.
How much you make in a year is not the same amount that you are taxed on. Someone can make $40,000.00 a year, but only be taxed on $23,000.00. Tax deductions, reduce how much of your income is subject to taxes. Deductions lower your taxable income by the percentage of your highest federal income tax bracket. So, if you fall into the 22% tax bracket, a $1,000.00 deduction saves you $220.00.
There are multiple deductions that one can take before coming to the amount of taxable income. The most recognizable one is the standard deduction. This is the amount one can deduct from their gross wages no questions asked. There is a different standard deduction depending on filing status; Single, Head of Household, Married Filing Jointly, Married Filing Separately, and Qualified Widower all have different standard deductions.
A taxpayer can do itemized deductions instead of taking the standard deduction. Itemizing your deductions means figuring out how much in medical expenses you paid for, how much in state and local taxes you paid, any mortgage interest, charity expenses and/or gambling losses. If those deductions are more than the standard deduction you may want to itemize. Since the 2018 tax year, the itemized deduction for state and local taxes (also known as SALT deduction) is capped at $10,000.00. This means that even if you paid $5,000.00 in state income taxes, $7,000.00 in real estate property taxes, and $500.00 personal property tax, you could only deduct $10,000 on the line for state and local taxes.
Certain business owners will also get the Qualified Business Income Deduction. Self-Employed individuals and many small businesses must use a Schedule C on their 1040 tax return to report their business income and expenses. Many people fail to properly report their income on the Schedule C.
The most common issue our office sees (and try to help people address) is that these individuals and/or businesses only have one bank account for business and personal use. This makes it very difficult to keep track of your income and expenses for tax purposes. We always suggest that you set up separate bank accounts for business and personal use. That way you can clearly track what is a personal expense and what is a business expense. On the Schedule C you must list your gross income and business expenses. The different between those things calculates your net income that is subject to self-employment tax.
Once you determine your taxable income you can now calculate how much tax you are supposed to pay to the government.
One important point to remember that deductions are not the same as credits. Tax credits directly reduce the amount of tax you owe, giving you a dollar-for-dollar reduction of your tax liability. For example, tax credit valued at $1,000, for instance, lowers your tax bill by the corresponding $1,000. Not all tax credits are 100% refundable, meaning that if you get a credit for $2,000.00 you may only be able to get $1,000.00 of that credit back in an actual refund.
A refund is a payment back to the taxpayer from the taxing authority because the taxpayer paid too much income tax to the taxing authority during the calendar year. Some people like receiving a large refund because they use that saved up money to pay for vacations or a down payment on a car or to pay off debt. Others may want to see that refund be smaller and pay less tax during the calendar year. If they choose the latter option, the taxpayer will see a bigger paycheck throughout the year and will have the freedom to do what they want with that extra money each pay period.
Remember that having a large refund is basically like having an interest free savings account with the government. Some taxpayers would rather have that extra money to invest themselves, while others don’t trust themselves to not waste that extra money throughout the year, so they don’t mind the government holding it for them.
If you have been owing taxes every year, it is a good time now in the beginning of the year to adjust your withholding with your employer or start to set aside estimated tax payments that are due quarterly. It is important to understand why you are owing and to adjust your situation to prevent it from happening.
When to File
When it comes to when to prepare and file your taxes, the earlier is 99.9% better. There are very few instances when we advise individuals to hold off on filing their returns early. Many people file an extension for the April 15th federal deadline; this is an extension to file your taxes, not pay. Those extensions are for 6 months and are only an extension to file your returns. If you end up owing taxes, you will have to pay some penalties on the amount owed, if you do not prepay your taxes before April 15th. Now, if you do file late and owe you are looking at a 5% penalty for every month you are late up to a total of 25%. If you do not get your taxes paid on time you could be subject to a failure to pay penalty of .5% per month you owe up to 25%.
If you find yourself with a significant balance owed on your taxes you have a few main options on how to deal with it. First is you can pay it off lump sum style. This would be your cheapest option but also the least likely to be a good option since you probably wouldn’t have owed in the first place if you can afford to pay it all in one shot now. Second is to get into a 3-to-6-month payment plan with the IRS. Puts a hold on collection activity while you take a few months to gather the funds to pay it off quickly.
Another option is getting into a 6-year payment plan, which provides that you will be paying a certain amount each month over 72 months. The quicker you can pay off the debt the more money it saves because interest continues to accrue, and penalties do as well for many years. If you owe more than $50,000.00, more options become feasible (and cost effective) and you should reach out to a tax professional to go over those options in more detail.
Checkout our downloadable guide to understanding your 1040 here.
Arthur Rosatti, Esq. is a licensed attorney authorized to represent clients with the Internal Revenue Service and the U.S. Tax Court. He has experience negotiating with various taxing agencies on behalf of individuals and companies. If you have concerns about your tax liabilities, making estimated tax payments, or correcting your withholding, schedule an appointment with our office.