Taxable income
After you've made the decision to itemize or not, most of the rest of your journey is downhill. Your taxable income is simply your AGI minus your exemptions minus your deductions.
This is the place where your filing status comes into play. If you're taking the standard deduction, your filing status determines the size of the standard deduction.
Head of household filers get a bigger standard deduction than single filers, and couples filing jointly get the biggest standard deduction. Couples filing separately get the smallest standard deduction, and this is just one example of the marriage penalty which for some reason is built into our tax system.
Your filing status also determines your tax bracket. For the same taxable income, singles pay more in taxes than head of household or married, filing jointly.
Settling up portion
After you've calculated your total tax liability, you come to what I call the settling up portion of the return. Here you add up the tax you've already paid, and any other taxes or credits that may apply to you.
Remember that credits are better than deductions. One dollar in deductions only reduces your taxes by maybe 28 cents, but one dollar in credits reduces your taxes by a full dollar. So you should get interested if you hear the word "deduction", but you should get excited if you hear the word "credit".
First, see if there are any tax credits that you might be able to take advantage of. There are plenty of little credits that special interest groups have pushed through like oil shale credits, but the three main credits are the foreign tax credit, the child care credit and the earned income credit.
There's also a credit for the elderly or disabled, but this won't help most people. Even if you're elderly or disabled, this will only help you if your income, including Social Security, is extremely low.
Although the foreign tax credit may seem esoteric, if you have money in a taxable mutual fund that has foreign holdings, this credit might save you money. You'll have to fill out Form 1116, which can be difficult, but remember that each dollar in tax credits reduces your tax liability by a full dollar.
Child care credit
The child care credit can save a typical family hundreds of dollars, depending on the family's income. Use Form 2441 to claim the child care credit.
You can use this form even if you pay a relative, like one of your parents, to watch your child. However in this case, your parent will have to report your payments as income, and pay Social Security and income taxes on it.
When you file Form 2441 to claim the credit, the IRS wants the Social Security number or Employer ID number of the person you paid for the services. The IRS uses this information to ensure that the person you paid reports the same income as you're claiming as an expense.
Although the child care credit can save you hundreds of dollars, there's a better way to save money if you need child care, especially if you're a higher income person. Remember that up to $5,000 in child care is not included in your income if your employer provides this money.
Earned income credit
Another credit worth looking into is the earned income credit.
This credit is basically a income redistribution scheme meant to help low-income taxpayers, and it can mean big bucks for you if you qualify. The formula is complex, but as an example, if you make $10,000 a year and have two children you might get a credit of over $3,500.
This is obviously big money and helps to explain why the earned income credit is rife with fraud. The other reason is that the EIC is a so-called refundable credit. If you qualify for this credit, you can get the money even if your tax liability is zero. In other words, just fill out some papers and the IRS might send you a check for thousands of dollars.
Because of this fraud the IRS is trying to watch EIC payments, but don't let that scare you. If you qualify, go ahead and claim the EIC. Even if your income is as high as $28,000 you still can qualify for the credit if you have two children.
Other taxes
After calculating your credits, you'll have to calculate any other taxes you owe. If you're self-employed, you'll have to pay the self-employment tax.
This is your Social Security and Medicare taxes. Since you're self-employed, you'll have to pay both your portion and the employer's portion, for a total of 15.3 percent of your self-employment earnings. Attach Schedule SE to show this tax
Among the other taxes is the so-called Alternative Minimum Tax or AMT. This is an entirely separate system of taxation which attempts to catch high income people who otherwise wouldn't pay much in taxes.
If you're a middle income person whose income arises mostly from wages, you probably won't have to worry about the AMT. But if you own a small business or rental real estate and have a reasonably high income, you might have to look into this area.
Payments
Now we come to the payments part. For most people, this means taxes that have been withheld by their employer. But if you're self-employed, receive alimony or are retired and living off of your investments, you'll probably have to make quarterly payments with Form 1040-ES to the Internal Revenue Service.
The IRS expects to be paid proportionally through the year, and if your quarterly payments aren't enough, you may have to pay a penalty for each quarter which you underpaid.
You'll also face a penalty if your total tax withholding for the year isn't enough. If you don't prepay at least 90 percent of this year's, or 100 percent of last year's tax liability, you'll owe a penalty.
However, most people won't have to worry about this, since about 80 percent of taxpayers get refunds. The average refund is about $1,200.
Refunds
In spite of the penalties for under withholding, getting a refund of $1,200 is probably a mistake. Getting a refund of this size means that you've lent the IRS $1,200 for an average of six months. And you didn't get any interest on your loan!
To reduce the size of your loan to the IRS, and increase your weekly take home pay, change your withholding. Ask your employer for Form W-4 which allows you to change your withholding allowances.
The form has instructions that will help you, but if you're receiving the average refund of $1,200, you probably can safely increase your withholding allowances by one. You'll still probably get a refund, but it should be much smaller.
However, by increasing your allowances by one, you'll have more take home pay. If you're having trouble saving, divert your increased take-home pay into a savings plan.