Income Tax 101

Here's a quick overview of the U.S. federal income tax:

Four Steps

Figuring your income tax involves four steps:

1. Find your total income.
2. Subtract your deductions: the result is your taxable income.
3. Apply the tax rates to find your tax.
4. Subtract your withholding and other payments and credits: the result is the tax you owe, or the refund you have coming.

Step 1: Total Income

Total income includes many kinds of receipts: wages, interest, dividends, business and partnership income, amounts you receive from IRAs and pension plans, alimony, lottery winnings — and the list goes on. Of special interest: it includes your profit from sales of assets such as stock or real property — in other words, capital gain. But some items aren't included. For example, total income doesn't include gifts you receive or life insurance proceeds.

Step 2: Deductions

Deductions come in four main flavors:

Business deductions

These deductions are claimed as part of the calculation of business income, so they're actually part of the determination of total income in Step One. But take note: deductions related to your investment activities are not considered business deductions.

Adjustments

These are deductions you're allowed to claim even if you don't claim itemized deductions (see below). Among the items here are your contributions to an IRA or Keogh plan, and alimony you paid. When you subtract your adjustments from total income, you arrive at an important number called adjusted gross income.

For a single filer in 2004 (not blind or over age 65) the standard deduction is $4,850.

Itemized deductions; standard deduction

Each year you're allowed to claim itemized deductions or the standard deduction, whichever is larger. Itemized deductions include such items as medical expenses, state and local taxes, mortgage interest — and investment expenses. If those items don't add up to a large enough total, you claim the standard deduction instead. Your standard deduction depends on your filing status and is adjusted each year for inflation. Most people find that the standard deduction is larger than the total of their itemized deductions. As your income grows, you're likely to see your itemized deductions grow also. When they become large enough, you should claim itemized deductions instead of the standard deduction.

The personal exemption amount for 2004 is $3,100.

Exemptions

You're allowed a deduction just for being you: a personal exemption. You're also allowed an exemption for each person who qualifies as your dependent. Like the standard deduction, the exemption deduction is adjusted each year for inflation.

When you've subtracted all of these deductions from your total income, the result is your taxable income.

Step 3: Apply the Tax Rates

Once you know your taxable income, you apply the tax rates to find out your tax. Most people do this quite simply by looking up their taxable income in a table supplied with their tax form. If your income includes long-term capital gain you have to perform a special calculation to obtain the benefit of the lower rate that applies to this type of income.

Step 4: Subtract Payments and Credits

A deduction reduces your taxable income; a credit directly reduces your tax.

The tax law allows you to claim certain credits that reduce the amount of tax you owe. For example, if you pay for child care, a portion of that expense may be allowed as a credit. And of course, you get credit for any tax you've already paid — including income tax your employer withheld from your paycheck and any estimated tax payments you made during the year. Subtract your credits and payments from your tax to find out how much you owe. If your payments exceed the tax, you're in luck: you have a refund coming!

by Kaye Thomas, author, Tax Guide for Investors

Updated December 27, 2004