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Most of us are satisfied with having our taxes done for us. However, if you want to be more successful at planning your financial future, you should have at least a basic understanding of how a federal tax return actually works. In this basic tax guide, you’ll find out about the five simple steps involved in preparing your tax return. You’ll also learn about tax deductions and credits and how they are different from each other.

Part 1: Overview - How Income Tax Is Calculated

Step 1: Figure out your taxable income.

You first add up all your sources of income (e.g. salary, wages, interest, dividends, business income etc.). This is your total income. But the government does not tax you on your total income. You are allowed to subtract various types of expenses, which end up reducing your taxable income. These expenses are called deductions and come in four flavors: adjustments, standard deduction, itemized deductions, and exemptions - more about that later. The less taxable income you have, the less income tax you will have to pay.

Total Income

- Adjustments
- Standard Deduction or Itemized Deductions (whichever is larger)
- Exemptions
________________________________________________________

= Taxable Income

If the amount is zero or negative, then your taxable income is zero.

Step 2: Calculate tax.

Look up your tax rate for your level of income and multiply it by your taxable income to calculate your tax. You can find your tax rate in a tax table that is included with your tax forms.

Taxable Income x Tax Rate = Tax

Step 3: Subtract Non-Refundable Credits

If you qualify for non-refundable tax credits, subtract them from the amount of tax you calculated earlier.

Tax - Tax Credits = Tax Less Non-Refundable Credits

If the amount is zero or negative, then your income tax is zero.

Step 4: Add Other Taxes to Calculate Total Tax

Under certain circumstances, you may owe other types of taxes in addition to income taxes. These can include self-employment taxes or unreported social security taxes. Add them to your income tax calculate your total tax.

Tax Less Non-Refundable Credits + Other Taxes = Total Tax

Step 5: Subtract Refundable Tax Credits and Payments to Calculate Amount You Owe / Refund Due

The government doesn’t want to wait for its taxes until you file your return. They make you prepay your taxes by withholding an amount from each paycheck. Of course, it’s only when you file your tax return the following year that you actually know how much tax you really owed the government. The withholding amounts are just estimates. In addition, you may qualify for refundable tax credits, which you get to subtract at this point as well.

Total Tax

- Payments
- Refundable Tax Credits
_________________________

= Tax Refund / Tax You Owe

Sometimes you will find the government took too much from you, so they will have to pay you back. That’s a refund. On the other hand, if it turns out you paid too little in tax, the government will ask you to pay up the remainder of what you owe. You may even have to pay penalties for failing to withhold more.

Part 2 - Deductions vs. Credits

Deductions and credits are two very basic concepts. Surprisingly, very few people seem to understand the difference between the two.

Tax Deductions

There are several types of deductions: adjustments, standard deduction, itemized deductions, and exemptions. When you subtract adjustments from your gross income, you arrive at an amount called adjusted gross income. Then you get to subtract either a standard deduction, which is an amount set by the government, or itemized deductions, whichever is larger. You would only want to itemize deductions if their total was greater than the standard deduction amount.

Consequently, adjustments are usually worth more than itemized deductions. The government decides which deductions can be used as adjustments and which deductions can be itemized. Adjustments are sometimes also known as above-the-line deductions while itemized deductions are also known as below-the-line deductions. Common adjustments include IRA contributions, educator expenses, health savings account contributions, student loan interest, and tuition and fees. Itemized deductions include, for example, mortgage interest, medical expenses, charitable contributions, and investment expenses.

After you have reduced your adjusted gross income by applying either your standard deduction or itemized deductions, you get to reduce it again by another type of deduction called an exemption. The amount of the exemption is set by the government. Everybody gets at least one exemption for themselves, more if they have dependents.

The value of an above-the-line tax deduction is easy to calculate. After you have subtracted all deductions, you arrive at your taxable income. At this point, you apply the tax rate for your income level to calculate your tax. The value of an above-the line tax deduction is just the marginal tax rate multiplied by the amount of the deduction. For example, if your marginal tax rate is 30%, then a $1000 above-the line tax deduction is worth $300. Basically, the deduction reduces your taxable income by $1000, which means you have to pay $300 less in income tax.

The value of an itemized tax deduction is a little harder to calculate. If you add up all itemized deductions and it turns out that they are less than the standard deduction, then the value of the itemized deductions is zero because you wouldn’t even use them. On the other hand, if the total amount of itemized deductions is greater than the standard deduction, they would be worth something but only insofar as they increase your tax savings above the amount you would save with the standard deduction. So you would subtract the amount of the standard deduction from the total amount of itemized deductions and then apply your marginal tax rate to calculate the tax savings.

Tax Credits

Unlike tax deductions, tax credits reduce the tax you owe dollar for dollar. They are applied after all deductions have been subtracted and after you have applied the tax rate to your taxable income. For example, if you qualify for a $1000 tax credit, then you will have to pay $1000 less in income tax for the year. Consequently, a tax credit is worth more than a tax deduction for the same amount.

There are actually two types of credits: refundable tax credits and non-refundable tax credits. In some situations, a refundable tax credit can be worth more than a non-refundable tax credit. If it turns out that you don’t owe any taxes (i.e. taxable income is zero), then a non-refundable tax credit won’t do you any good. It won’t increase your refund. Similarly, if you have some taxable income but your tax is less than the refundable tax credit, your tax will be reduced to zero but the difference won’t be added to your refund. A refundable tax credit, on the other hand, doesn’t just decrease your tax debt, but it can also be used to increase your refund. Most working taxpayers, however, won’t be faced with this problem because their taxes won’t be low enough to make a difference.

Some of the most common non-refundable tax credits include the foreign tax credit, the education tax credit, and the child tax credit. Refundable tax credits include, for example, the earned income credit, the first-time homebuyer credit, and the recovery rebate credit (for tax year 2009).

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