We have all had the thought at least once in our lives… ‘what on earth is going on here’? Going over your tax return can easily be one of those moments. Having a professional to ask questions and help you walk through and explain it is an excellent source of information. Here I will go through some highlights of a general tax return, and something very specific to those in the law enforcement occupation.
The most important thing is that a tax return (the 1040) reads top to bottom. I will lay out a way of how it flows, but when looking at the actual tax form, we go top to bottom.
My brain always tries to break things down into the more simple way of looking at it, before I can add any complexities. So a tax return starts with how much income you made, then you calculate how much tax that income should pay. You then compare it to how much you have already paid during the year (such as withholding from your paycheck). So, income creates tax, tax minus anything paid already = bottom line. Either you have additional tax due (because not enough was paid already) or are due a refund (because you paid more already than the tax that was due). If it was really this simple – one, I wouldn’t have a job, but two, and most importantly – we would all pay a lot more taxes than we currently do. This is just a baseline to get it started.
Enter the big word ‘deductions’. Deductions reduce your income – which is awesome because your tax is calculated based on your income. The most common source of deductions comes from either the standard deduction or itemized deductions, and we add a new part to our simple look of a tax return. Income – deductions = taxable income. Tax is calculated from the taxable income, not the first part of income. So, income – deductions = taxable income -> tax – withholding = bottom line of your tax return.
There are deductions that work differently than the itemized deductions, and they go in a different spot. These deductions are things like student loan debt, IRA contributions, etc. Most are subject to an income limitation (if you make too much money, you can’t take the deduction). These deductions go against your income before deductions and create what is called your adjusted gross income, or AGI – which is another magic tax word. A lot of limitations are based on AGI. Now we progress to Income – limited deductions = AGI – deductions = taxable income -> tax – withholding = bottom line. Because the limited deductions are not consistent for everyone, it is generally ok for estimate purposes to think of your total income as your AGI. It isn’t perfect, but it gets you close enough for ballpark purposes – but it cuts out some of our growing formula for taxes. AGI – deductions = taxable income -> tax – withholding = Bottom line.
Credits are different from deductions; they go between the tax and the withholding line and effect the bottom line number much more dramatically. Credits are also fairly few in number; the most common is the child tax credit for kids under 17 on December 31st of the year. A $2,000.00 deduction only changes the bottom line by the rate at which the tax would be imposed on it. 10% tax on $2,000.0 is $200.00 bucks, thus that deduction only saved $200.00 of tax. Still good to have, and it is more valuable the higher tax bracket you are in. However, a $2,000.00 credit, goes against the tax number directly, which affects the bottom line on a 1 to 1 basis, just like the withholding from your paycheck. AGI – deductions = taxable income -> tax – credits – withholding = bottom line.
We are almost to the important stuff I promise!
Now we add a sad line to our flow of the tax return. Additional tax. There are a few things that add more tax than the normal tax calculated from your taxable income. Withdrawing money early from a retirement account carries a 10% penalty on the amount withdrawn. Doing self-employed work (1099 extra jobs) carries something called self-employment tax which is roughly 15%. The nasty – and important part to understand about this additional tax is WHERE it goes in the total calculation for the bottom line. It is after tax and before withholding. AGI – deductions = taxable income -> tax – credits + additional tax – withholding = bottom line. [For those super savvy, yes, there are some credits that come in between additional tax and withholding, but that is an extra layer of complication that isn’t totally necessary for our purposes here] The challenge with the additional tax being here, is that deductions do not affect the additional tax number. Say for example as is happening all over the world – natural disaster takes your home. Under certain circumstances, you can take a pretty big deduction for that and it is possible that your taxable income is $0.00. Guess what the tax is on $0.00? $0.00. You would expect 100% of what was withheld from your check (federal withholding) to be refunded to you… Unless you have one of these additional tax numbers, again like extra jobs. If you had $10,000.00 of extra jobs, you would have $0.00 of tax calculated from your taxable income, and then you would ADD the ~15% from your $10,000.00 of extra jobs and still have a tax liability of about $1,500.00, which you then compare to how much was withheld from your check.
Finally, the good stuff. (Especially if you work in Law Enforcement or are self-employed in some way)
Self-employed work can be reported on form Schedule C. The Schedule C allows you to report your gross self-employed earnings, subtract your deductions directly related to those earnings in particular and come up with a ‘profit’ number. That profit number get slid in as part of your income, or AGI. This means that your gross earnings are not taxed, only the net. It also means that you can take these deductions in addition to your itemized or standard deduction. Further, the self-employment tax (the additional tax) is calculated from the net earnings. By correctly reporting these deductions for your self-employment income (extra jobs) you save both the regular taxes AND the additional taxes. This does still not create a 1:1 ratio for your deductions, making your self-employed expenses ‘free’… but it does illustrate how very impactful those deductions are!
Please take care to keep track of the things you spend; they can make a big difference to your tax return. Additionally, be careful to prepare for the tax impact your self-employed work will bring. If you anticipate a stark change in self-employment income, please consider a tax consult with a professional. Many have said, ‘knowing is half the battle’. Know how impactful your deductions on extra jobs can be, but also keep in mind why – because of the additional tax they are helping to help offset, but that will still be present on the rest of your net.
Income (Earnings and net self employment earnings) – limited deductions = AGI – itemized / standard deduction = taxable income -> tax – credits + additional tax – withholding = bottom line.
Charles Steinmetz
Senior Tax Advisor
