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Tax season is a high risk, high reward time of year. Unfortunately, if you – like many – find yourself perplexed by borderline unintelligible tax codes, you may fall victim to penalties and legal repercussions from the IRS.
Having a firm grasp of the tax code at all levels of government, on the other hand, can save you hundreds (if not thousands) of dollars via deductions and credits.
You don’t need to be a tax expert, though. Knowing the basics can help you file your return correctly and pay or get paid the proper amount. Follow this guide to master tax season.
The various forms of income, deductions, and credits can be overwhelming, but knowing the differences can make tax season much more manageable. Let’s look at some of the most important terms you need to know.
Your filing status determines the rate at which your income is taxed, your filing requirements, and your eligibility for certain deductions and credits.
Your filing status depends on your personal circumstances as of December 31st of the tax year. The two main factors are your marital status and your dependents.
There are five filing statuses.
- Single: You’re unmarried, divorced, separated by court order, or your spouse is deceased as of December 31st of the tax year.
- Married filing jointly (MFJ): Married couples may file a joint tax return. This filing status provides you more tax deductions and credits, lowering your tax bill. Both spouses are equally responsible for the return’s accuracy as well as any tax owed, though.
- Married filing separately (MFS): Married couples can also file separately. You lose out on several benefits, but in certain situations, MFS could make sense. For example, if you keep your finances separate, filing a separate return ensures that you are not responsible for any portion of your spouse’s tax liability. Another example would be spousal income disparity. If you earn $1 million per year, while your spouse earns $60,000, they can file separately to enjoy benefits only offered in lower tax brackets.
- Head of household: You’re unmarried on the last day of the tax year, and you’ve cared for a dependent who lived with you for more than six months during the tax year. Head of household provides better tax rates than other filing statuses. Additionally, if you’re married but file separately from your spouse, the head of household filing status entitles you to certain credits and deductions not available with the MFS status.
- Qualifying widow(er): If your spouse dies during the tax year, you can still file MFJ or MFS. In the subsequent year, you can file as a qualifying widow(er) if you’re still unmarried and have a dependent child. Qualifying widow(er)s receive the same tax benefits as MFJ filers.
If you qualify for more than one filing status, you may select the one that provides the optimal tax benefits.
Earned Income: Earned income is derived by providing services to others. Wages, tips, and professional fees are examples of earned income.
Unearned income — also known as passive income — is derived from activities that do not involve a direct service. Forms of unearned income include:
- Capital gains
- Rental income
- Retirement distributions
- Social security
Your gross income is the sum of your income from all sources — earned and unearned — before taking any deductions or exemptions. Income is not limited to cash, either. Property and services that you receive may count as income. The only forms of income not included in gross income are those specifically exempt from taxation via the Internal Revenue Code.
Adjusted Gross Income (AGI) is your gross income minus deductions (below-the-line deductions, as discussed below) specified by the IRS. For example, you may have earned $100,000 last year, but after specified deductions, your AGI may only be $80,000. AGI influences your eligibility for many other deductions and credits.
Taxable income is your AGI minus below-the-line deductions, discussed below. This is the amount from which the IRS calculates your tax liability.
Modified Adjusted Gross Income (MAGI) is your AGI with certain items added back. The IRS phases out certain credits, deductions, and other benefits based on how large your MAGI is. For example, if you’re married filing jointly and your MAGI is above $103,000, the IRS reduces the amount of IRA contributions you can deduct on your return.
Above-the-line deductions, sometimes called adjustments to income, are the deductions mentioned above used to figure your AGI. You can take these types of deductions, whether you take your standard deduction or you itemize. Examples of above-the-line deductions include:
- Alimony payments required under divorces or separations executed before December 31st, 2018 (not child support or settlement payments)
- HSA contributions
- IRA contributions
- Moving expenses related to job or business
- Student loan interest
- Self-employment tax (50%)
Below-the-line deductions are subtracted from your AGI to arrive at your taxable income. You can either take your standard deductions below-the-line or itemized, depending on which one minimizes your tax burden.
The standard deduction is a flat dollar amount the IRS lets you subtract from your AGI, in lieu of itemized deductions. It exists to simplify tax filing for people without complex tax situations — it’s easier to deduct a flat dollar amount than to keep receipts for every deductible expense. The total amount differs based on filing status, ranging from $12,200 for single filers, $18,350 for heads of household, and $24,400 for married filing jointly.
However, for certain individuals (usually those with higher incomes), itemized deductions may be more advantageous. Common itemized deductions include:
- Casualty/theft losses: Losses from unexpected, unusual, or sudden events such as natural disasters or theft. Total losses must exceed 10% of your AGI, and each loss is subject to a $100 minimum deduction threshold. For example, if your home suffered $10,000 in damage from a bad storm, your $1,000 laptop was stolen, and your AGI was $30,000, you would add $900 ($1,000-$100) to $9,900 ($10,000-$100), then subtract $3,000 ($30,000 x 10%) to arrive at $7,800 in deductible losses.
- Charitable donations: You can deduct up to 60% of your AGI through charitable donations. For example, if your AGI were $50,000, you can deduct up to $30,000 from your AGI. There are smaller limits for certain charitable organizations.
- Mortgage interest: Deduct mortgage interest paid for buying, building, or improving a primary residence. Second homes/vacation homes also qualify with limitations. Cannot be used for investment properties — properties you own primarily to make a profit.
- Unreimbursed medical and dental expenses: Any qualified medical expenses in exceeding a certain percentage of your AGI (7.5% for Tax Year 2019) that your insurance did not cover. For example, if your 2019 AGI was $50,000 and you had $7,000 in medical expenses, you would subtract $3,750 ($50,000 x 7.5%) from $7,000 to arrive at $3,250 in deductible expenses.
- Various taxes: Personal property, state, local taxes are deductible, although the IRS has several rules you must follow.
Credits are tax incentives subtracted directly from your total tax liability, reducing what you owe dollar-for-dollar. Some credits are refundable, meaning they can turn your tax owed into a refund if large enough. Some of the most used credits include:
- American Opportunity Credit: Education credit. Deduct up to $2,500 in qualified education expenses per eligible student according to IRS guidelines.
- Child Tax Credit: Deduct up to $2,000 per qualifying child and $500 per qualifying dependent according to IRS guidelines.
- Earned Income Tax Credit: Supports low- and moderate-income families with qualifying children. Pays an amount equal to a percentage of earnings based on several factors per IRS guidelines.
- Lifetime Learning Credit: Education credit for low- to moderate-income families. Deduct up to $2,000 in qualified education expenses per return.
- Saver’s Tax Credit: Non-refundable credit for taxpayers that contribute to workplace retirement plans as well as traditional and Roth IRAs. Deduct a certain percentage of your plan contributions based on your AGI and filing status.
Tax Brackets and Rates
Our tax structure operates on a progressive slope, meaning that you owe a higher rate if you earn more. The tax brackets range from 10%- 37%, depending on your taxable income, and the amounts increase with inflation every year.
Now, the rates in each tax bracket can change if the government introduces legislation to do so. For example, the 2017 Tax Cuts and Jobs Act — which went into effect on January 1st, 2018 — lowered the rates for all brackets except for the 10% and 35% brackets. These two brackets did not change. For more information, check out the 2020 tax brackets here.
Marginal Tax Rate
In the US, the IRS does not tax your entire taxable income at your bracket’s rate. Instead, we use a marginal system, whereby you apply each bracket’s range to its respective range of income. Your marginal tax rate is the rate of the highest bracket in which you owe tax.
A variety of taxes are included in the marginal tax rate, such as federal, state, and local income taxes, as well as federal payroll and self-employment taxes.
Let’s say that in 2019, you made $102,500 and filed as single. You’re not getting taxed at 24% on all $9,700. In reality, you would be taxed 10% on the first $9,700 of your income, 12% of the amount that falls within the $9,701 to $39,475 threshold, 22% on the income that falls within the $39,476 to $84,200 threshold, and 24% on the remainder, which would fall in the $84,201 to $160,725 range. It would work out as follows:
- 10% x $9,700 = $970
- 12% x $29,475 = $3,537
- 22% x $44,725 = $9,839.50
- 24% x $18,300 (remainder of your income) = $4,392
Total tax owed = $18,738.50
Your marginal tax rate would be 24% in this case, as it’s the highest tax bracket in which your income is taxed.
In contrast, your effective tax rate is the actual percentage of income that an individual taxpayer or corporation will owe the IRS.
Individuals can calculate their effective tax rate by dividing their total tax expense by their total taxable income. Corporations must divide the total tax expense by the company’s earnings BEFORE taxes to find their effective tax rate.
Consider the incomes of two individuals based on the tax brackets for 2019. Person A made $50,000, and Person B made $42,000. They would both be taxed 10% on the initial $9,700 of their respective incomes and 12% on the next $29,475. Since they both made enough income to reach the 22% bracket, that portion of each of their incomes will be taxed the same.
However, Person A’s remaining income is taxed at 22% ($10,525), while the remainder for Person B is just $225. That comes out to $2,315.50 in taxes on the 22% portion for Person A, and a scant $49.50 for Person B. All totaled up, Person A would pay $6,822.50 in taxes, while Person B would pay $4,556.50. While both individuals would top out in the 25% tax bracket, Person A is paying an effective tax rate of 13.6%, while Person B is paying an effective tax rate of 10.8%.
Knowing your effective tax rate can help you determine how much you need to withhold from your paycheck to minimize your tax or refund (since a tax refund means you gave an interest-free loan to the government) when you file. If you’re Person A in the previous example, you’d want to withhold $5,400 ($50,000 x 10.8%) for the entire year.
Now that you understand tax terms and brackets, you should have a better understanding of what you owe and why you owe it. Let’s cover some other helpful tax information, starting with extensions.
A tax extension provides you additional time to prepare and file your tax return. A common misconception is that tax extensions give you more time to pay the tax you owe. They do not, as you still have to pay your taxes by April 15th.
Buying into this misconception can be costly, as you’ll owe penalties – extra amounts enacted for failing to pay taxes — in the same manner as if you had paid your taxes late for another reason.
That said, the IRS charges a much higher penalty if your tax return and tax payment are both late. If you are in this unfortunate situation, filing an extension can minimize your penalties by eliminating the late filing penalty and leave you only with smaller late payment penalties.
There is no penalty for filing an extension on your taxes, as long as you do so by the April 15th filing deadline. You must still pay what you owe by April 15th, though, regardless of whether or not you file an extension.
To file an extension, fill out IRS Form 4868, labeled as the “Application for Automatic Extension of Time to File US Individual Income Tax Return.” You can retrieve Form 4868 from the IRS’s website. Unless you live and work outside of the States and Puerto Rico, you must file your extension by the date your return would normally be due.
You can file an extension electronically. Most tax return filing sites and programs have E-filing tools that help you file your extension in minutes, and you’ll receive an email confirmation when you send your extension and when the government receives it.
When to File an Extension
The IRS does not require you to provide a reason for requesting an extension. They approve nearly every request, only rejecting requests if information on Form 4868 is incorrect.
Here are a few cases in which filing an extension makes sense.
Incomplete Tax Documentation: An extension is a good idea if April 15th is approaching soon, but you’re waiting for documentation to arrive. If you estimate income, you’ll likely have to correct your return later anyways.
Complex Return: If you have an especially complex tax situation, you may want extra time to complete it. By filing an extension, you can work with a tax professional to ensure you maximize your deductions, as well as to verify the accuracy of all information on your return.
Life Events: Tragic life events such as illness, deaths in the family, or natural disasters can get in the way of you filing your taxes. If critical issues such as these are present in your life, you should file an extension so you can tend to them first.
Can I File an Extension for IRA Contributions?
No. IRA contributions for a tax year are only deductible if made before that tax year’s regular filing deadline.
As mentioned earlier, tax extensions are handy if you do not yet have the documentation to complete your return. If you guess at any information on your return, you put yourself at a higher risk of an IRS audit, which we’ll cover next.
An IRS audit is a review or examination of an individual’s or organization’s tax returns, accounts, and financial information to verify that information is reported correctly on tax returns. You could one day face an audit of yourself or your business.
I’m Being Audited. Am I In Trouble?
Although you should take an audit notice seriously, being audited does not always mean you’re in trouble. Some audits are random, while others are made to verify information on your returns that the IRS finds questionable. In either case, you’ll have to provide sufficient documentation to back up the information in question.
Should you be unable to support an item on your return, the IRS may simply send you a bill for the new amount owed with a penalty factored in.
Types of Audits
The IRS conducts three types of audits, each one increasing in its severity. Remember, IRS representatives are trained at getting you to admit damaging information that could cause you to owe additional tax or penalties. No matter which type of audit you experience, you should always seek legal advice/representation from a tax attorney.
- Correspondence audits are the most common IRS audit type, making up about 75% of all audits. The IRS conducts these types of audits for simpler tax matters and smaller monetary amounts. In a correspondence audit, the IRS sends you a letter requesting more information about a return or proposing an adjustment for overpayment or underpayment. You then have to respond with sufficient documentation to prove your case. If you agree that you owe the new amount the IRS has proposed, you’ll have to pay it as soon as possible.
- Office audits used are for situations larger than appropriate for a correspondence audit.
The IRS will send you a letter requesting that you visit an IRS office for questioning. In general, office audits involve interviews regarding business profits/losses, rental income/expenses, or itemized deductions. The IRS may also ask you about your employment and financial situation.
- Field audits, generally conducted on businesses, are the most comprehensive type of audit. During a field audit, the IRS will come to your home or business to look through your business records. Additionally, they may interview you or your employees or ask you to provide them a tour of the premises. Using this information in conjunction with your records, the IRS can gain a deeper understanding of your business’s structure and operations.
Sometimes, the IRS conducts field audits on individuals. In this case, they’ll examine your financial records in deeper detail and interview you. Now, the IRS sends revenue agents to conduct these audits. Revenue agents are more experienced and skilled in their duties and tend to specialize in specific industries. For this reason, legal representation is of the utmost importance.
Tips for Reducing Your Audit Chances
Although many factors could set off an audit, there are things you can to reduce the chances of it happening to you.
File correctly: Inaccuracies can attract the IRS’s attention — they may become curious about other mistakes, intentional or accidental. Consequently, filing a complete and accurate return is the easiest way to minimize audit chances. Make sure to include all relevant tax documents as well as any explanations and addendums.
Report all of your income: Employers are required to send a copy of W2s and 1099s to the IRS, meaning the IRS knows your income before you do. If their system detects a discrepancy between what you provide and what they have — intentional or otherwise — your return could be flagged for audit. Triple check every number and piece of documentation you have for accuracy before filing.
Be cautious with deductions and credits: In general, the IRS cares much more about you underpaying than they do about you overpaying. Because of this, claiming deductions and credits that you aren’t entitled to can attract their attention. Always triple check your deductions and credits so that you don’t make errors that trigger an audit in their system.
Credits are of particular concern, as they are generally harder to claim and can have a much more significant impact on the amount of tax you owe. Additionally, the IRS has lost a lot of revenue to fraudulent claims of some credits, such as the Child Tax Credit and Earned Income Tax Credit.
Find good tax preparation help. If your return is complicated, you may want to hire professional help. Businesses already hire tax preparers regularly, but more individuals are turning to experts to ensure accuracy. The cost may be worth it if you can save on your tax bill, reduce the chances of an audit, and prevent a late filing/payment that will cause you to incur penalties.
However, not all tax preparers are created equal. Some are out there for the sole purpose of preying on people who may not know how to protect themselves. These fraudulent actors will charge unsuspecting folks who pay substantial fees up front for sub-par work or incorrect returns and then disappear. In the eyes of the IRS, however, you are responsible for the information on your return — not your preparer.
There are three main types of tax preparation professionals:
- Enrolled Agents (EAs) are licensed by the IRS and are trained in tax preparation, planning, and representation before the IRS. EAs must pass a three-part exam that covers individual tax, business tax, and representation. They must also pass background and credit checks and are responsible for completing 72 hours of continuing education in tax every three years.
- Certified Public Accountants (CPAs) are licensed by their state’s accountancy board and must pass the rigorous four-part CPA exam. They must meet various other ethics, education, experience, and character requirements. Lastly, they must complete extensive continuing education each year. CPAs can specialize in any accounting subfield, including tax preparation and planning. Make sure to find a CPA specializing in individual tax for individual returns and business tax for business returns.
- Tax attorneys: Tax attorneys are attorneys that specialize in tax matters. Although tax attorneys can assist you in preparing your return for a premium, they are more often employed in representing you before the IRS and tax courts in matters of audits and other tax-related legal issues.
Today, tax software has made filing taxes on your own easier than ever, but the US tax system remains quite complicated. The IRS holds you ultimately responsible for filing complete, timely, and accurate returns, so it’s critical to understand the basics of tax.
However, you don’t have to do it all yourself — and you shouldn’t if your returns are complex. When in doubt, get professional help. The fees you’ll pay to your tax specialist will be well worth the money you’ll save, the audits you’ll avoid, and the peace of mind you’ll gain.