Here’s how it works. You make money—maybe lots, that’d be neat. The government wants a piece of that action, so they ask you to file a Form 1040 that calculates what their share is. And if the 1040 could speak to you, this is what it would say:
- Income: Okay, first we've got to figure out how much money you made. I hope you kept your W-2's and 1099's because they'll tell you the exact number. Don't try and mess with me. The person who sent you your W-2's and 1099's sent the IRS a copy too, so we know how much you really did make.
- Adjusted Gross Income: Okay, so I'm not a total ogre. I'm not going to tax you on all of that. I'll let you subtract out some things like moving expenses and your student loan interest. Because you subtracted some stuff from your gross income, we'll call it your "adjusted" gross income, or AGI (that's the kind of jargon that sets you apart as a member of the cool club).
- Itemized or Standard Deductions: And hey, I like you so much, I'm going to let you subtract out some more things from that number. I'll even give you two options for what you'll subtract. Option A is the "gimme" standard deduction that everyone gets (based on your filing status), or, you can go add up all these things I'll call "itemized deductions" and subtract those out. Here's a pro-tip for choosing between itemized deductions or the standard deduction: take whichever one is bigger.
- Exemptions: And the generosity continues! I'll also let you subtract out $3,800 (in 2012-- the number usually goes up a little each year for inflation), for everybody's name listed on the front of the return-- you, your spouse, your kids.
- Taxable Income: Okay, so now we're at the magical number called taxable income. We took all your income and subtracted out several things to get to the number we'll actually multiply by the tax rate. (See this post to learn how tax brackets work).
- Tax: This is how much tax is due on your income.
- Tax Credits: If you qualify for any of them, I'll let you take a tax credit against that amount (kind of like a gift card in that it reduces the actual dollar amount you owe the government). Some common tax credits are education credits or the child tax credit.
- Other Taxes: Okay, while you're here. Let's just make it convenient for you to pay some other separate taxes, like self-employment tax or household employment taxes (you may owe these if you employ a nanny). We'll just add those in to our total due.
- Payments: Now that we know how much you owe, let's figure out how much you've already paid. This includes amounts withheld from your paycheck (this will be listed on your W-2) and amounts you sent in as estimated payments. There are also certain credits, like the Earned Income Credit that appear down here as payment options because unlike the ones in item 7, you can use them to pay your "other taxes" we talked about in step 8 as well.
- Refund/Amount Due: Now we know if you get a refund or if you still owe me money!
See, not so bad, right? Now when the next tax season rolls around, you can go show that 1040 who's boss!