An Introduction to Income Tax – Understanding Form 1040

In my first few years as a financial planner, taxes were not my best topic. I preferred to help clients choose investments and make recommendations about retirement plans. I learned quickly that having at least a basic understanding of taxes is crucial to any aspect of the financial planning process. The goal of this article is to share the basic tax concepts which I think each person should know for general street smarts. I’m going to focus most of the article on what the steps are to filling out a 1040, the basic individual tax return. Through this explanation you’ll begin making sense of terms like adjusted gross income, standard deduction, tax credits, etc.


Form 1040 is the basic tax return for individuals and may be used by any taxpayer. It’s a two-page form which includes several supporting “schedules.” The number of schedules one needs to fill out depends on how the taxpayer receives income and which deductions or credits the taxpayer may be eligible for. For example, Schedule A is for your itemized deductions. If you itemize your deductions rather than taking the standard deduction (something we’ll discuss this further down) you need to elaborate on those deductions on Schedule A. Here is a list of the other five schedules:
Schedule B – Interest and Ordinary Dividends (income from investments)
Schedule C – Profit or Loss from a Business (self-explanatory)
Schedule D – Capital Gains and Losses (from investments made throughout the year)
Schedule E – Supplemental Income and Loss
Schedule SE – Self-Employment Tax
Some people pay in estimated taxes throughout the year so they don’t get stuck with a giant bill at the end of the year. This is done either automatically through a payroll service or through quarterly payments if you are self-employed. Others overpay on purpose so they get a definite refund at the end of the year. The form you get from new employers that determines how much tax you will have wittheld from your paycheck is Form W-4. Print one out from irs.gov and read the information on top. You’ll see this form each time you take a new job. I’m now going to discuss the steps taken to calculate your income tax.
1 – Figure out your “Gross (Total) Income” for the year.
Your gross income includes every source of income you have coming your way during the year except for those items specifically excluded. Examples of income are salary, commissions, interest from investments, business income, rents, partnership income, tips, royalties, etc. Some examples of those items specifically excluded from income are proceeds from a life insurance contract received by reason of death, inheritances, and interest from tax-exempt organizations such as municipal bonds.
2 – Subtract Deductions to get your “Adjusted Gross Income.”
These deductions will reduce your gross income to the figure we call “adjusted gross income.” This is a very important figure in the business world. It’s the last line on the first page of form 1040. Common examples of deductions are contributions to qualified retirement plans (IRA’s), higher education expenses, interest paid from student loans, moving expenses, health insurance deductions, teacher’s out-of-pocket education expenses (up to $250), one-half of the self-employment tax, etc. The rules for deductions are a bit elaborate, so it’s best to check with irs.gov if you have questions about a possible deduction. Tax credits, which are even more valuable, will be discussed later on. The important thing to realize here is that each deduction will be subtracted from your gross income to help compute this “adjusted” number. If you are taxed at a 28% rate and deposit $4,000 into a traditional IRA, you are saving roughly $1,100 on your taxes as a result ($4,000 * 28%). As you can see, paying attention to your allowable deductions can be worth a lot of money to you.
3 – Determine your Itemized Deductions
Once you figure out what your adjusted gross income is, you can subtract from that number either your standard deduction ($5,150 in 2006) or your itemized deductions, whichever number comes out higher. It’s important to think through this calculation before just using the standard deduction, because you might have very high itemized deductions. Homeowners, for example, because they can deduct mortgage interest, will generally itemize their deductions. Here is the short list of what you can itemize:
• Medical expenses that exceed 7.5% of adjusted gross income
• State and local income taxes
• Real estate and personal property taxes
• Mortgage interest on both primary and secondary residences
• Investment Interest Expenses
• Charitable Contributions
There are also “Tier II” itemized deductions which are deductible only to the extent that the cumulative total exceeds 2% of adjusted gross income. These deductions include:
• Expenses related to preparing your taxes or investment advice
• Unreimbursed business expenses (transportation, home office, etc.)
If you decide to itemize, you add all these numbers up on Schedule A to arrive at your total figure for itemized deductions. You then deduct this number from your adjusted gross income to reach the next part of form 1040. If you use the standard deduction, you don’t have to fill out schedule A and just drop in $5,150 (if your single, $10,300 if you’re married) into the appropriate box.
4 – Determine your Personal Exemptions
This is a friendly item on the 1040. You will further reduce your tax base by your personal exemption. You can claim an exemption for yourself, your spouse, or your children. The personal exemption amount in 2006 is $3,300, and indexed annually for inflation. There are rules you can read on irs.gov which explain what a “qualifying child” or “qualifying relative” means for you to claim that exemption. There are income phaseout levels for the personal exemptions. If you are married and earning above $225,750, you will begin having trouble taking child exemptions.
5 – Arrive at a Figure for your Taxable Income
You subtract your exemptions to get your “taxable income.” This number started as your gross income and deductions were then taken to arrive at your “adjusted gross income.” Your standard or itemized deductions were then subtracted, followed by your personal exemptions. You base your tax on this final figure.
Once you figure out how much tax you owe, take a look at how much you’ve already paid in. You’ll either be entitled to a tax refund, or have to pay in additional money.
Determining what tax you owe is based on tables (or nowadays tax software). We have a progressive tax system in the United States which means you’re going to pay increasingly higher tax bills as your income passes certain thresholds. You pay 10% tax up to your first $7,550 worth of come. You then pay a 15% rate from $7,550 to $30,650. That rates jumps to 25% for earnings from $30,650 to $74,200. 28% from $74,200 to $154,800, and 33% for $154,800 to $336,500. The highest tax rate is 35% for those earnings in excess of $336,550.
6 – Consider Tax Credits
These are extremely valuable when you qualify for one. A tax credit will reduce the tax you owe dollar-for-dollar. For example, if after filling out your 1040 you see that you owe $2,400, but qualify for the $1,500 Hope Credit, your tax bill will only be $900. This is much better than a deduction which reduces your taxable income, not your dollar-for-dollar owed tax. Again, irs.gov is the best source for finding out about tax credits. Here is a short list of some tax credits that will be relevant in 2006.
• Child Tax Credit
• Qualified Electric Vehicle Credit (new)
• Credit for Dependent Care
• Adoption Tax Credit
• Retirement Savings Contribution Credit
• Mortgage Interest Credit
One final point about tax credits is that they cannot trigger a tax refund. If you owe $800 in tax and have a $1,000 credit, your tax liability becomes 0. The government will not allow issuance of a credit to create a liability for them.
The 1040 is a form every taxpayer must fill out. Resident Income Tax Returns are the form you must fill out for the state you live in. The information on here is similar to the 1040, and having an understanding of the 1040 will make the state return easier to understand. Please note that the above information will cover most questions coming from a salaried employee of a company. If you own your own business, the tax you pay will depend on your form of business. Some corporations (such as LLC’s) have pass-through provisions which allow the income from the corporation to pass-through to the individual owners. If you are not a salaried employee, gather information about your specific entity, whether a sole proprietorship, partnership, or corporation.
As always, please e-mail me with any questions. I am a financial advisor located in Manhattan. My blog is for information purposes only and was started as a financial planning resource to my clients and friends.
Russell Bailyn

Wealth Manager
Premier Financial Advisors, Inc
14 E 60th Street, #402
New York, NY 10022
P: 212-752-4343 *31
F: 212-752-7673
rbailyn@premieradvisors.net
Securities and certain investment advisory services offered through: First Allied Securities, Inc., a registered Broker/Dealer. Member: FINRA/SIPC. Premier Financial Advisors, Inc. is a Registered Investment Advisor. First Allied Securities & Premier Financial Advisors are not affiliated entities.

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