King of Spades

As a continuation to my article on Tax Tips, Deadlines and Discount, how about we run through a simple hypothetical example of a federal tax return using the IRS rules for 2016 taxes (which are being filed now in 2017)? Whether you’re filing taxes for the first time, or you want a snippet of how to do it yourself, this may be useful to you. It helps to have Microsoft Excel, but since I don’t have Excel capabilities here, nor the ability to write this out on a Form 1040, bear with me.

Again, before we begin, I have to mention that this website and its contents do not constitute as financial advice and you are solely responsible for completely and accurately reporting your taxes to the United States Internal Revenue Service. Seek a qualified tax professional for any questions or concerns you may have.

Forms and Figures

Your W2 comes in and it says your taxable income is $65,000. You withheld $7000 in federal taxes. In this example we are going to ignore state taxes because each state has different rules and forms.

Your 1098-E comes in and it says you can deduct up to $400 in qualified student loan interest payments.

Your 8889 comes in and you contributed $1000 into your HSA, and took $300 out of your HSA to pay for a qualified medical expense.

Your 1099s come in and you took $0 distributions from your Traditional IRA (smart move), you received $10 in dividends from your Money Market mutual fund at your financial institution, $390 in dividends from other domestic mutual funds you own, and you traded only three stocks. One of them you held for more than one year, invested $1000 and sold it to receive $1500 (you made a $500 profit). Another one you held for less than a year, invested $1000 and also sold it to receive $1500 (keep raking in that dough). The last one you held it for a few years, it has lost you money all that time so you decide to sell it and take a loss of $200 (you win some and you lose some, but Einstein called compounding interest the 8th wonder of the world so don’t stop investing).

One last note about the Traditional IRA mentioned earlier. Even though it’s not on a tax form that you’ve received yet (on purpose), you know that you’ve contributed the max $5,500 you’re allowed to contribute in 2016 per IRS rules. You contributed $3000 in the actual 2016 calendar year, and you contributed the remaining $2,500 in 2017 between January and April 17.

I hear you saying “I see a lot of numbers and this does not sound simple it all.” It is, once you see the logical flow of things. Follow along with me step by step, and if you have either a physical or PDF copy of a Form 1040 you’ll be able to see things a little easier.

Tax Return Steps

Step 1 – Personal Information

“Wait what? I thought we were about to do math.”

Yes we are, but you’d be surprised at how many people have their identity stolen or have a tax return filed in their name before they even get to do the math. Do yourself a favor; ensure that your name, address, employment info, SSN, and all other personal info is accurate. It only takes a few minutes and ensures the IRS’ fraud prevention systems catch discrepancies or red flags later on if they exist.

Step 2 – Filing Status and Exemptions

Not necessarily math yet, but it doesn’t help to start your taxes if you don’t know what your tax status is (and therefore what type of tax brackets you need to refer to). For the sake of this example, we will assume your filing status is single and the corresponding tax brackets can be found on this Forbes article.

Regarding exemptions, this is where as a single tax payer you can claim 1 personal exemption of $4,050 per 2016 IRS rules. You will see later that that number will be used to reduce our taxable income.

Step 3 – Income

Now the math begins. So we have $65,000 in taxable job income, $10 in money market divs, $390 in mutual fund divs, $500 and another $500 in stocks trading profit, and that $300 we took out from the HSA. So that’s $66,500 in taxable income, right? Not exactly.

The dividends, no matter how small, are indeed reportable. So we do have $400 in dividend income to report (10+390).

The stock trades that resulted in capital gains (profit) are different however. One of them was the result of holding the stock for more than one year, and the other was held for less. As such, per IRS rules, the “more than one year” trade is considered a long-term capital gain and is taxed at a lower rate than the “less than one year” short-term gain. Take note here that it is more beneficial from a tax perspective to hold on to stock investments for the long term rather than the short term.

Given that we will most likely end up in the 25% overall tax bracket (because our taxable income will end up somewhere between the lower $37,651 threshold and the higher $91,150 threshold), the long-term cap gain will therefore be taxed at a 15% rate. To follow where I got that rate from, check out this article about capital gains taxes to explain further.

Back to the math. So the long-term gain will be taxed at 15%, which leaves it as a $75 taxable income (substantially different than $500). The other $500 gain that was short term will be taxed at your normal tax bracket, which in this hypothetical example as mentioned previously is 25%. That leaves a $125 taxable income. Total taxable gain is $200, right? We forgot something. The $200 capital loss from the third stock you held onto for a while. When you’re filling out Schedule D on your Form 1040 to report net capital gains or losses, you need to add everything together. In this case, your net capital gain is $0 ($200 gain minus $200 loss).

“If that’s the case, do I even need to go through all the trouble of doing this math and reporting it to the IRS?” If you don’t want to potentially get audited later and assessed penalties or fees, than yes. Remember that any forms you get the IRS gets as well, and that includes the cost basis and proceeds from stocks or other brokerage activity you have.

“Alright, so now we just need to add that $300 distribution from my HSA for qualified medical expenses to my taxable income. I’m curious though, if it’s a qualified medicial expense does that mean something?” Yes it does. It means that it is actually not taxable if indeed it is qualified. For sake of this example, let’s just assume it really is. All you have to do is report it on your Form 1040 but it’s not actually counted towards your taxable income.

To wrap income up, the total income is $65,000+400+0+0= $65,400.

Step 4 – Adjusted Gross Income

In this section you will include things such as your HSA deductible contributions, your student loan deductible interest payments, and your IRA deductible contributions (see any common words there?).

In our case, we have $1,000 in HSA contributions, $400 in student loan interest payments, and $5,500 in pre-tax IRA contributions.

“Quick question. I only contributed $3000 into my IRA in 2016, remember? The other $2,500 was only done this year in 2017. Doesn’t that mean I can only deduct the $3k?”

Thankfully, no it does not mean that. Per IRS rules, individual tax payers have until the personal tax filing deadline (i.e., April 18, 2017) to make contributions to their IRA for the previous tax year. As such, we can continue with the full $5.5k deduction.

Going down the line, that’s a total of $6,900 in deductions. So our total AGI is $65,400-$6,900 = $58,500. Now we’re talking, our taxable income has gone down.

Step 5 – Tax, Credits, and Other Taxes

Here is where we start to figure out how much we owe in taxes. Before we do that though, we have to apply two more things: the standard deduction and the personal exemption.

In our example we will not be itemizing deductions but instead taking (with pleasure) the standard deduction of $6,300 provided by the IRS per 2016 rules. Now our taxable income drops down to $52,200. Next, we will take (again with pleasure) the personal exemption provided by the IRS which is $4,050 for single filers in 2016. Now our taxable income drops down to $48,150.

Take a moment to look at the difference from where we are now to where we were before. This is the advantage of making pre-tax contributions to eligible accounts, balancing nice capital gains with modest capital losses, and taking advantage of the deductions provided to you freely. Though this is a simple example, it’s important to see why you should be educated on how to file your tax returns so that you can take appropriate financial actions throughout the year accordingly. We’re not even talking about the tax benefits of owning a home, having a small business, or being enrolled at a university while working if you can.

Now to see what you owe in taxes. With a $48,150 taxable income, your tax can be found by taking “$5,183.75 and adding 25% of the amount over $37,650” (refer back to the table here).

$48,150-$37,650= $10,500

25% of $10,500 = $2,625

$5,183.75+$2,625= $7,808.75

The IRS rounds their numbers, so your total tax is $7,809. In our example we are going to assume there are no credits or more taxes to add, so that is the final figure.

Step 6 – Owe or Refund?

Let’s look at our W2 and see what we withheld for the IRS from our paychecks. We mentioned earlier it was $7000. That’s $809 short of our final tax due. Since we did not withhold money from any other place (like some retired people do when they withdraw money from their IRAs or 401(k)s and other retirement accounts), that means we owe the IRS $809. Bummer. We’ll pay of course, but after we’re done we might consider submitting a new Form W4 to our employer in order to withhold more money from our paychecks, if possible, going forward for next year.

Step 7 (Final) – Pay or give instructions on how to receive refund, sign and send

In this case we owe, so we’re either sending the IRS a check by mail with our physical Form 1040 or paying by credit or debit card when filing our taxes online. An electronic signature online via a service such as TurboTax is equivalent to a physical signature on the form. Once you send it, it’s a done deal and any action needed afterwards may cost you money and or time. So be sure to check and review your math, forms, and personal info before submitting.

Congratulations, you’ve finished the Mock 1040 Tax Return!

As stated in my previous article, if you’d like an easy to follow, user-friendly software to help you file your taxes, I would recommend TurboTax as they are the software I use personally. You can receive a 20% discount on filing your federal return, if you use this link here.

I hope this was insightful for you. Remember that stewarding your finances (the tool used to obtain food, water, clothing, and prosperity, and to help others) wisely is a skill that can set you up for success in life. “Do you see a person skilled in their work? They will stand before kings.”