What Everyone Ought to Know About Their Income Tax Returns – Part 5


Congratulations! You’ve made it to the end of learning the fundamentals of your income tax return. A couple of more steps, and you will have discovered what you need to know to navigate your way through your return and hopefully reduce the anxiety you have over preparing it.

As a recap, here is where part 4 left off on your income-tax-return formula:

Gross Income – adjustments = AGI

AGI – (standard OR itemized deduction) – personal exemptions = taxable income

Taxable income –> Tax table = tax

The last way of reducing your tax involves taking tax credits.

A credit differs from an above-the-line or below-the-line deduction in a very important way. A credit reduces your tax liability dollar for dollar (e.g., a credit of $1000 reduces your tax liability by a $1000), whereas a deduction only reduces your tax liability by your marginal rate (e.g., an above-the-line deduction of $1000, if you fall within a 15% marginal rate, reduces your tax liability by $150).

In addition, some credits are refundable.  So even if the credit exceeds your tax liability, you will get the excess back.  As such, credits play a crucial role in reducing the tax you pay.

The Essential Credits

You will find nine essential credits on your Form 1040, and I could spend an entire post on each of them. For now, I want to simply highlight the credits as a starting point for more research if you find one that fits your situation.

  • Foreign Tax CreditA credit for foreign tax paid on foreign income to reduce the burden of double taxation from the United States and a foreign country.
  • Credit for Child or Dependent CareA credit for expenses paid on child and dependent care.  The credit can be as much as $3000 for one qualifying individual or $6000 for two or more qualifying individuals.
  • Education Credits –The American Opportunity Credit and the Lifetime Learning Credits apply to expenses for higher learning. The maximum amount for the American Opportunity credit is $2500, with $1000 of it being refundable. The Lifetime Learning Credit can be as much as $2000.
  • Retirement Savings Contribution CreditA credit for lower income workers who contribute to a workplace retirement plan.
  • Child Tax CreditA refundable credit up to $1000 for each eligible child.
  • Residential Energy CreditsA credit for expenditures on improvements or appliances that boost energy efficiency in a home.
  • General Business Credit A combination of several business credits that can be taken by an individual, including carry forwards (tax credits you want to use on future years) and carry backs (credits you want to use on prior years). 
  • Credit For Prior Year Minimum TaxA credit for Alternative Minimum Tax (AMT) caused by deferral items. (This credit will make more sense later when I discuss AMT.)
  • Earned Income CreditA refundable federal income tax credit for low- to moderate- income working individuals and families. Arguably, this credit benefits low- and moderate- income families more than any other.  

Again, each credit has qualifications and restrictions beyond the scope of this post, so make sure to do more research.  I have linked to the instructions or other helpful IRS sites on these credits to provide some insight into the rules for each one.

Other Taxes and Payments

Now that you have figured out your income tax liability, you may need to add other taxes such as self-employment tax or an early withdrawal penalty. Those additional taxes plus the income tax make up your total tax.

Our final formula looks like this:

Gross Income – adjustments = AGI

AGI – (standard OR itemized deduction) – personal exemptions = taxable income

Taxable income –> Tax table = tax

Tax – credits + other taxes = total tax

Once you have your total tax, you take into account payments you have made through methods like withholding from your employer or estimated tax payments to determine whether you get a refund from the government or owe them money.

Your Roadmap

And there you have it: your roadmap for navigating your way through your income tax return. I hope you have found this series helpful in understanding your Form 1040 and anxiety reducing in having to prepare it.