As we’re busy working through tax returns this season, we kept noticing a recurring theme.  What’s that you may ask?  Well, it’s the fact that there are a number of taxpayers who don’t have a clear understanding of how the tax system works.  What do we mean by this?  Keep reading.

A week ago we were working on a clients return.  She had a modest income and produced various deductions that had in fact reduced her tax able income to zero.  When she mentioned that she had some other items and we entered them in, she was perplexed that her refund didn’t increase.  Well, we walked her through her return and showed her how she no longer had a tax liability and was only entitled to receive back what she had paid in.  We then explained that deductions reduce taxable income rather than directly increase your refund.  No one had ever told her this!

So with that being said, here is a brief overview of how the tax system works for most wage earning individuals (i.e. W2 employees).

Income  What you take home from your job, what your bank pays you in interest, what your investments earn you in dividends and what your state gives you for a tax refund.  All of these things get added up and total your income.  This is where the calculation starts, but this is far from where it ends.

Deductions  Did you pay interest on a student loan?  Are you a teacher and pay for supplies used in your classroom?  Did you make a contribution to a 401(k) or another pension plan?  All of these amounts get subtracted from your income.

Taxable Income  Once you take the income and subtract deductions, you wind up with something called Adjusted Gross Income (AGI).  From here you get to take another set of deductions (the standard or you’ll itemize) and you get an exemption for every person in your household.  AGI minus the above yields your taxable income which is just what it sounds like, the amount you actually are taxed on.

Tax  So the next step is to take your taxable income and determine how much tax you have to pay on it.  Pretty straightforward.

Credits The important thing to know about credits versus deductions is that credits reduce your Tax on a dollar for dollar basis.  Do you qualify for the Earned Income Credit (EIC)?  Did you pay to go to school and qualify for an education credit?  These things will reduce your tax where a deduction only reduces your taxable income.

Payments  This is what you had taken out of your check to cover your tax.  It’s pretty much as simple as that.

Refund or Balance Due  If the amount of your payments are greater then your tax (less credits), congratulations, you’ll get a refund.  Didn’t have enough withheld from your check to cover your tax?  Sorry, looks like you have a balance due.

And that in summary is how the system works.  The important things to take away from this are:

  • Deductions reduce your taxable income.  They don’t necessarily increase your refund.
  • Credits are worth more than deductions.  Always see what credits you qualify for as some of them change from year to year.
  • Make sure you pay enough into the system or you will owe.  You can adjust your withholdings via Form W4 with your payroll or HR department.