Learning The Basics In Taxation
By: Dr. Peter Ikre
The month of January is unique in many ways. Aside from ushering a new year, it epitomizes the period when taxpayers reconcile their accounts with Uncle Sam via the Internal Revenue Service (IRS). The 2016 tax season began in earnest a few weeks ago (01/19/2016 to be precise). In light of this development, I’ve compiled a few notes to refresh/further taxpayers’ basic knowledge of the tax structure.
•The U. S. tax system is progressive in nature.
•It means that the more you earn, the higher your tax bracket (rate).
•There are 7 tax brackets: 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%.
•Your tax rate depends on 2 factors: a) taxable income and b) filing status.
•Your filing status depends on your marital and family situation on December 31st (last day of the year).
You can only belong to one of five options for filing status:
b) Married Filing Jointly (MFJ)
c) Married Filing Separately (MFS)
d) Head of Household (HH)
e) Qualifying Widow or Widower with Dependent Child (QW).
To qualify as Head of Household (HH), one must meet the following requirements:
a) Remain unmarried on December 31st (last day of the year)
b) Pay more than ½ of all the expenses involved in running a home.
c) Must have had a qualifying dependent living with you for more than half of the year.
To achieve the Qualifying Widow/Widower status, the following requirements must be met:
a) The surviving spouse must have been eligible to file a joint return in the year of death of the other spouse.
b) Currently unmarried.
c) Can claim a child/step-child as a dependent.
d) The child lived with you for more than half of the year.
e) You paid more than ½ of all the household expenses for the year.
•For tax purposes, the Qualifying Widow/Widower (QW) and Married Filing Jointly (MFJ) are the same with respect to the tax brackets and standard deduction.
•In other words, QW is allowed to use the tax rates and standard deduction reserved for MFJ.
1) Tax Forms
The major form for individual income tax return is Form 1040. There are other variations of the form, such as Form 1040 EZ. However, in nearly all cases, we use Form 1040. The form comprises two pages with early parts devoted to personal information, such as name, address, telephone number, filing status, etc. The other sections of the form inquire about all types of income (wages, salaries, dividends, interests, etc) and deductions (above-the-line and below-the-line deductions). I’ll come back to the differentiation later.
Form 1040 is not a standalone document. Certain materials are attached to it. They are known as schedules and serve different objectives depending on the user’s intentions.
Schedule A: For those wishing to itemize their expenses rather than use the standard deduction option, Schedule A is the place to list and sum up all the year’s expenditures.
Schedule B: It is used to report interest and dividend income (1099-INT and 1099-DIV)
Schedule C: This is the popular Profit or Loss schedule for the self-employed taxpayer (Sole Proprietor).
Schedule D: It is used to report capital gains and losses.
Schedule E: A platform to report income or loss from rental properties, partnerships, royalties, S-corporations, etc.
There are essentially 4 classes of income.
a) Ordinary income- wages, salaries, self-employment income
b) Investment or Portfolio income- interest and dividend
c) Passive income- rental income
d) Capital gains
Emanate from your expenses, for example, interest you pay on student loans.
There are two types of deductions available to the taxpayer: a) Standard deduction and b) Itemized deductions. You must select one of the two.
Standard deduction figures vary according to filing status. For instance, single taxpayers and married individuals filing separate tax returns are allowed $6300 standard deduction for 2015 tax year, whereas married couples filing jointly can deduct $12,600 each.
Itemized deductions, sometimes known as below-the-line deductions, are used by taxpayers who consider the standard deductions inadequate to cover their year-long expenses. They are called below-the-line deductions because they reduce the adjusted gross income (AGI). Examples include charitable contributions, real estate taxes, and mortgage interest payments.
If a deduction cannot be categorized as itemized or below-the-line deduction, it means it must be an above-the-line deduction. The wonderful thing about above-the-line deduction is that any taxpayer can use it irrespective of whether you apply standard deduction or itemized deduction in your returns. They reduce the gross income. Examples include student loan interest payments, traditional IRAs, and Health Savings Account contributions.
Exemptions: Anyone willing to be part of the tax process is entitled to an exemption. In other words, a taxpayer is allowed an exemption, one for the spouse, and one for each of the dependents. The value of an exemption changes according to the wishes of those in power. For the 2015 tax year, it is $4000 per individual. In addition, exemptions reduce the adjusted gross income (AGI).
Credits: They are often the result of Congress rewarding or assisting certain segments of the population, such as students, low-income people, or individuals contributing toward their retirement. Examples include Earned Income Tax Credit (EITC), Child and Dependent Care Credit, Retirement Savings Contribution Credit, and the student credits (American Opportunity Credit and Lifetime Learning Credit) to mention a few. Credits are fantastic because they lower your taxes in a very direct manner.
Refunds: Paychecks are issued every two weeks to most employees in the country. Before they arrive, the government withholds taxes for Social Security, Medicare, and your income. The refund process is very simple. If the amount withheld for income tax purposes exceeds the tax computed during the tax season, you are due for a refund! If on the other hand, the computed tax surpasses the withheld amount, you owe Uncle Sam big time! Sometimes, we advise taxpayers to adjust their withholdings by making necessary changes on Form W-4.
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