The Beginner’s Guide to Income Taxes (United States)
In this guide I’m going to outline the important things you need to know about income taxes in the United States. Here is an outline of what I will be covering:
- Income Tax Forms
- Income Tax Schedules to File with Your Forms
- Tax Credits
- What Are Capital Gains Taxes
Disclaimer: The following information is not to be considered accurate. It’s likely that this information is outdated as the government adds new tax provisions to the tax policy for Americans each year. I’m not a CPA, Attorney, or any professional so the information below is general educational content not intended to be advice. Consult a legal tax professional before making decisions.
Income Tax Forms 101:
This blog post will fill you in on all the tax form terminology when it comes to reporting income. You may have heard different forms such as W2, W9, 1099, and more so dive in and begin your edge-uh-mi-cation.
W2 – If you work as an employee for an employer, this will be the form that is used. Your employer should provide it to you.
- How much income you made
- How much your employer withheld (federal tax, state tax, social security, medicare)
1099 – a form for independent contractors that the contractors will receive from their clients.
W9 – This is an information gather form for employers. They can use it for verification purposes and it usually is never mailed to the IRS. They’ll transfer the information from this form onto a 1099 form which will be the actual form used for income reporting.
990 – This form is for non-profit organizations. A non-profit organization will lose its tax status if it fails to file this form for 3 consecutive years. In other words, if your organization hasn’t filed in the last 2 years you better file this year before you lose tax status as a non-profit.
5500 – This is a form for the reporting of your Employee Benefit Plan if you are a business owner. It protects the rights of participants and beneficiaries.
Business Entity Returns
1065 – Partnerships must file this form
1120 – C Corporations must file this form
1120S – S Corporations must file this form
1120C – Cooperative Associations must file this form
1120H – Homeowners Associations must file this form
1041 – Estates & Trusts must file this form
Employment Payroll Taxes
940 – Employers annual federal unemployment tax return
941 – employers quarterly federal tax return
706 – U.S. Estate Tax Return to report estate taxes
709 – U.S. Gift Tax Return to report gift taxes
1098 Series Forms
1098 – Report mortgage interest (which is an itemized deduction)
1098E – Report student loan interest (which is an above the line adjustment on your 1040)
1098T – Tuition statement that may provide you an above the line adjustment or tax credit
You’ll likely come across several of these tax forms throughout your lifetime and for business owners and entrepreneurs, you’ll see some different forms than most people so it’s important to learn what forms will be used in your respective fields of work.
What Are Tax Schedule Forms
When it’s time to file taxes each year you must submit an income tax form to the government along with any required schedule forms.
Forget what the word “schedule” usually means for a second because for tax purposes it basically is just a form where you’ll list certain items and dollar amounts.
The income tax form you fill out will either be the 1040 (most common) or in special cases you may fill out a 1040A or 1040EZ. And then attached to it will be a schedule which we list below for different types of uses.
The formal definition: A form required by the IRS that you must prepare in addition to your tax return when you have certain types of income or deductions.
Schedule A – You must attach this form with your 1040 if you decide to itemize deductions. This form lists out all of your itemized deductions. If you total your deductions up and it is less than the standard deduction the government is allowing you to deduct, then throw out your schedule A and take the standard deduction so that you reduce your taxes owed.
Schedule B – This is an income schedule where you’ll list sources of interest and dividend payments you receive during the year. You need to fill it out if your income exceeds the IRS threshold – $1,500 (2015)
Example: If you earn $900 in dividend income, you must include it in your taxable income but since you didn’t reach the $1,500 threshold, filling out a schedule B won’t be necessary.
Schedule C and C-EZ – this tax form is for listing self-employment income. You’ll need to calculate your business net income by including all business earnings and deductions. Your net income or loss you calculate on this schedule will then need to be added as income on your 1040 in the gross income section.
*C-EZ is a more simple form for businesses that meet IRS qualifications.
Schedule D – this form is for reporting the sale of an asset. You may have sold stocks, your home, or a car. These sales are broken into short term and long term because each is taxed differently due to capital gains rules.
Learn about Capital Gains Taxes and their effect on building wealth
Schedule EIC – this form is to report qualifications for earning the Earned Income Tax Credit. The EITC is a tax credit for low income families with qualifying children.
Read about tax credits you should be taking advantage of in our upcoming article. Stop by this link.
Schedule SE – This is the form you self-employed business owners must fill out to report their social security payment.
Itemized Deductions to Take Advantage Of
This section dives specifically into a list of itemized deductions you should be taking into consideration when filing taxes as they may apply to you.
When it comes time to file taxes, you will be faced with the choice of itemizing deductions or taking the standard deduction.
The standard deduction is a straight up amount the IRS allows you to deduct from your taxable income such as $12,000 for individuals, $18,000 for heads of households, and $24,000 for married couples.
There are also itemized deductions you can subtract from your taxable income. These are individual items you’ll list on a Schedule A.
Many tax payers don’t realize certain items are tax deductible and leave them off their filing. This costs you money over the long run that could impact your retirement. Take advantage of these by talking with your accountant to see which ones apply to you.
Itemize These Deductions
Disclaimer: I am not a tax adviser, consultant, or anything related to taxes. This information is not to be considered accurate and for every item on the list there are certain rules and restrictions that apply. Do not just take them as they are because there are rules by the IRS as to what is eligible and not eligible. Further research on your part is required.
The List of Deductions:
- Student loan interest
- College tuition and fees
- Tax preparation expenses
- State and local sales tax
- Dependent care flex spending account
- IRA contributions
- IRA losses
- 401k contributions
- Health savings account contributions
- Penalty for early withdrawal of savings
- Business use of your car
- Business travel expenses
- Job search expenses
- Moving expenses
- Military reserve travel expenses
- Medical and dental
- Mortgage interest
- Mortgage points
- Mortgage insurance premium
- Points paid on home improvement loans
- State and local real estate taxes
- Business use of your home
- Educational expenses
- Appraisal fees
- Fees to collect interest and dividends
- Investment fees and expenses
- Repayment of income
- Legal fees
- Safe deposit box rental fees
- Gambling losses
- Educator expenses
- Casualty, theft, and disaster losses
- Non cash donations
- Donating your time and services
- Employee business expense
- Self employed health insurance
- State balances due
- Union dues
- Work uniform expenses
- Turning 65 or older deduction increases
- Vehicle registration fees
- Jury duty
Again, this is a small list of possible deductions to itemize on your income tax schedule so it’s important to consult with a tax professional to analyze deductions that apply to your lifestyle expenses.
Once you’ve deducted all that’s legally allowed, you should have a lower tax bill and feel great that you saved money that can be invested to create more wealth or spent on fun activities with the family.
What Are Tax Credits?
If you’ve ever heard of tax credits but are still confused on the concept, today’s lesson should help clear up the fog for you and help you feel more aware next year during tax season.
Tax credits are different than tax deductions so it’s important to distinguish between the two. Let’s begin.
Comparing Tax Credits to Deductions
Deductions and exemptions reduce the amount of your income that is taxable on a percentage basis whereas tax credits are dollar for dollar subtractions off your tax liability.
Simple Terms: One subtracts your taxable income, the other subtracts your final tax bill.
Tax credits are last second adjustments to your tax liability. It’s like the government steps in and says
“hey we will pay X amount of your tax bill, so please take this credit from us to apply towards your bill”
How Tax Credits Work
Example: You have a Taxable Income of $10,000
If you were to subtract $5,000 in deductions leaving you with a taxable income of $5,000 which will be taxed at 10% since it falls under the $9225 limit (2015) for that bracket. You’ll owe $500 in taxes.
The government gives you a $1,000 Dependent Care credit for the expenses of child care you paid out to a third party while you worked at your job.
This would be applied to your $500 tax bill leaving you surplus $500 right? Correct, so the government paid your $500 tax liability and then the other $500 goes in your pocket. Nice!
Beware though that only certain tax credits are refundable. The tax credits that are not refundable will only wipe your liability to $0 and then that’s it. If there is a surplus, you do not get the refund of what’s left of the credit.
Check out this list of tax credits that are refundable:
- The Earned Income Tax Credit – for qualifying families with low incomes
- The Child Tax Credit – for qualifying people who have a child
- The American Opportunity Tax Credit – for qualified tuition and expenses
Why Tax Credits?
Governments may grant tax credits to promote/reward specific behavior(s) that are considered beneficial to the economy, environment, or other purposes that the government has deemed important to society.
Seems like a smart way to motivate people right? See which credits you may qualify for that you haven’t been taking advantage of when filing taxes!
Two Tax Credits That Help Millions
Millions of people are helped each year by the Earned Income Tax Credit and the Child/Dependent Care Tax Credit.
1. Earned Income Tax Credit – if you’ve earned under a certain amount of money then you are eligible to claim this credit. It varies based on how many qualifying children are claimed by you; the more children, the higher the threshold is for maximum income allowed to be earned.
You also must have a social security number and must have earned at least $1. There are even more qualifications you must meet besides the few listed. You can learn more from the IRS website directly by visiting this link: http://www.irs.gov/Credits-&-Deductions/Individuals/Earned-Income-Tax-Credit
2. The Child and Dependent Care Credit – it is calculated based on the expenses paid for the care of your kids under age 13 to enable you to work or look for work if you’re unemployed. The limit for amount of expenses you can use to calculate the credit is $3,000 for one child and $6,000 for two or more children.
Again, the figures listed aren’t the tax credit amounts but are the expense amount limits you can claim that will factor into the calculation of the tax credit amount you’ll receive.
According to the IRS website, your tax credit will be roughly 20% to 35% of your allowable expenses.
Other Important Tax Credits To Know
Adoption Credit – The credit for an adoption of a child with special needs in 2015 is $13,400. For other adoptions in 2015, the max credit is the amount of qualified adoption expenses up to $13,400.
Kiddie Tax – There used to be a loophole where parents would put income in their kids’ names to get out of paying as much taxes. The kiddie tax now addresses that tax hole. The threshold for tax free unearned income is $1,050 in 2015. Then the next $1,000 is taxed at the child’s tax rate. Unearned income above $2,000 results in kiddie tax which is normal marginal tax based on the parents tax bracket.
The Child Tax Credit – You can get up to $1,000 credit for having a dependent child and you are allowed to claim this along with the Child & Dependent Care Credit
The American Opportunity Credit – this credit will be maxed at $2,500. It is comprised of $2,000 from tuition and related expenses plus 25% of excess expenses up to $2,000 excess. Income restrictions apply.
Lifetime Learning Credit – If you didn’t claim the American Opportunity Credit then you may be eligible for a credit up to $2,000 per year that pays for qualified tuition and required enrollment fees at an eligible educational institution. Income restrictions apply.
Credit for Elderly and Disabled – must meet certain qualifications to be eligible for this tax credit
Saver’s Credit – Low to moderate income earners get help for retirement saving. Tax credit up to 50% of the value of your contributions to retirement account.
Premium Tax Credit – Low to moderate income families who bought health insurance through the Health Insurance Marketplace at Healthcare.gov
Foreign Tax Credit (5022 Form) – this credit will help reduce the double taxation burden for citizens earning income outside of the U.S.
Residential Energy Efficient Property Credit – If you’ve spent money on qualified solar electric systems, qualified solar water heaters, qualified fuel cell property, qualified small wind energy, or geothermal heat pumps then you can receive 30% of these expenditures as a credit.
Mortgage Interest Credit – you must contact a government agency to acquire a mortgage credit certificate (MCC). However much tax credit you receive for the mortgage interest must be subtracted from the itemized deduction “mortgage interest” so that you don’t double deduct. The tax credit is better since it’s an after tax deduction. See why credits are better than deductions.
Non-Business Energy Property Credit – you may be eligible for a 10% credit on energy-efficient improvement expenditures such as windows, doors, and roofs.
Low Income Housing Credit – if you own rental property in low income housing areas you may be eligible for this credit. It’s an incentive to get investors to help improve the low income housing area and respective buildings.
11 Tax Free Gross Income Sources
Wouldn’t it be cool to make money and not be taxed for it? Well there is a list of income sources or income savings that are considered tax free in the eyes of the IRS that I’d like to share with you:
1. Employee Gym Benefits – If your employer provides you with benefits when you are hired, they are usually taxed. In the case of gym benefits, you are exempt from employee operated gyms. Offsite gym benefits are taxable.
2. Employee Achievement Awards – certain restrictions apply such as it has to be tangible personal property.
3. Employee Gifts – when coworkers or employers give you holiday gifts that are physical products the cost of these gifts is not included in your income.
4. Employee Parking Passes – up to $230 of employer paid parking in most cases is not taxable. Seek irs.gov for details.
5. Employer Provided Car – if you’re given a vehicle for business, only the business portion is not taxable. Personal use of the vehicle is taxable.
6. Gifts & Inheritances – in most cases these aren’t included in your gross income section of the 1040
7. Workers Compensation – amounts you receive as workers’ compensation for an occupational sickness or injury are fully exempt from tax if they are paid under a workers’ compensation act or a statute in the nature of a workers’ compensation act.
8. Health Savings Account (HAS) – contributions made by your employer to your account are not taxable and withdrawals for qualified medical expenses are not included in your income.
9. Life Insurance Proceeds – in most cases these proceeds are not taxable
10. Disaster Relief Payments – qualified relief payments are not considered income
11.Welfare and other public assistance benefits. Don’t include in your income any governmental benefit payments from a public welfare fund based upon need.
Capital Gains Taxes 101 For Beginners
Did you know that any time you sell a capital asset for a capital gain or profit there is likely a capital gains tax to be paid?
Capital gains tax is an important topic to understand as it will impact your ability to grow your wealth snowball.
If you don’t know what capital gains are or what capital gains tax is then don’t worry as I will lay it out for you in simplest terms and examples for you today so that you can walk away with a mini MBA in investment taxes.
What is a capital asset?
Anything an individual owns for personal or investment purposes. So pretty much most things in your life but the most popular items that people talk about are:
- Real Estate
What is a capital gain?
When you sell an asset for a higher price than you paid for it, it is considered a capital gain.
The cost of purchase to use as a basis for later on when you sell includes the sales price of course but also includes:
- Sales taxes, excise taxes and other taxes and fees
- Shipping and handling costs
- Installation and setup charges
- Improvement Costs
As stated, adding all of these additional costs to the purchase price, results in a total cost that is used as a basis for comparing the sale price.
Depreciation can reduce your assets worth or basis price which is why some assets that are sold fail to qualify as capital gains and are instead considered capital losses.
Capital losses can be beneficial in terms of reducing your taxable income so that you pay less income tax.
Short Term & Long Term Capital Gains
How your capital gain is taxed depends on the duration you held on to the asset. The IRS has two tax classifications called short term capital gains tax and long term capital gains tax.
- Short Term Capital Gains Tax – An asset or investment you hold for less than a year
- Long Term Capital Gains Tax – An asset or investment you’ve had for longer than a year
Short term gains are taxed at your normal income tax.
So whatever income tax bracket you fall in when it comes time to do taxes will be used also for taxing your short term capital gains.
Long term gains are taxed at a lower rate than short term gains. You can think of it as the IRS trying to give you an incentive for holding on to your investments.
Long Term Gains Tax Chart
- If you fall in the 15% tax bracket or lower you pay 0%
- If you fall between 25% and 35% you pay 15%
- If you fall above 35% you pay 20%
Paying 20% when you’re in the 35% bracket is still a good deal as you’re saving 15% in taxes by holding long term which can be a substantial saving considering someone in this tax bracket makes above $400,000 per year and likely invests big sums of money as well.
Being tax savvy can keep more money in your pocket and help your wealth snowball get rolling much quicker.
A Capital Gain Example
Here is an example regarding stocks:
If you purchase $5,000 worth of stocks and let’s say you’re using an online brokerage such as Scottrade, then you’ll have a $7 broker fee for a total cost of $5,007.
If you then sell your stocks for $6,000 you’ll have a capital gain of $993 that will get taxed by the government.
At the short term rate well say you have to pay 25% because your taxable income fell in the 25% tax bracket. Say goodbye to roughly $250 of your $1,000 profit.
At the long term rate, you’d have to pay 15% tax since you fall in the 25% tax bracket. Say goodbye to only $150 and hello to the $100 dollars that stayed in your pocket you would have paid out had it been a short term investment gain.
Capital Losses Offset Capital Gains
When you have multiple transactions throughout the year you’ll have a mix of short and long term capital gains as well as short and long term capital losses. These losses offset against your gains reducing the taxable income.
If you happen to face a loss after totaling your gains and losses, then this can be carried over to offset gains of future years.
You must fill out Form 8949 and Schedule D, where you’ll discover that losses are categorized as short-term and long-term, just like gains.
The value of the deductible loss depends on how the loss is applied. Sadly, the taxpayer doesn’t get to choose.
Here’s what to do:
- Short-term losses counterbalance those expensive short-term gains. What’s left at the end of Part I of Form 8949 is the net short-term capital gain or loss. If there were no gains, then obviously the net would equal the total loss.
- Long-term losses are applied to long-term gains. The result, at the end of Part II of Form 8949, is the net long-term capital gain or loss. Again, if you only have a loss, then the net is a negative number.
- Next, you combine the short-term and long-term results on Schedule D. At this point, a loss in one section can offset a gain in the other section. For example, if you have a net short-term loss of $1,000 and a net long-term gain of $1,200, then you’ll pay tax on only $200.
- If there’s still a loss, you can deduct up to $3,000 from other income.
- If you had a really bad year and ended up with a net loss of more than $3,000, you can carry forward the leftover portion to next year’s taxes. The unused loss can be applied to next year’s gains, as well as up to $3,000 of earned income. A big loss can be used as a deduction indefinitely — another important reason to keep good records.
Disclaimer: I am not a certified accountant, tax advisor, financial adviser or any other professional related to investing and taxes. This information is for educational purposes only and should not be considered true or factual. Please seek professional assistance with further questions related to taxes and investing.
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