It’s natural to feel a little squeamish when you’re faced with a lot of rules and potentially dire repercussions if you misunderstand them, and many people face this challenge at tax time. A basic understanding of tax laws can save you some money on antacids and maybe even on your taxes, too. You may not be ready to call yourself an expert and hang out your shingle to prepare other's returns, but knowing these rules can go a long way toward peace of mind when you roll up your shirtsleeves to prepare your own.
Here’s an overview of what you need to know when you file your personal income tax return, and even as you do a little tax planning for next year's return.
Do You Absolutely Have to File?
Not everyone has to file a personal income tax return. In fact, if Social Security benefits were your only income last year, you may not have to. Disability insurance payments aren’t taxable and don’t require the filing of a return if that’s the only income you had, and the same applies to Supplemental Security income. If your sole source of income doesn't come from a job or investments, check with a tax professional to find out where you stand.
So what happens if you earned just a little income? Whether you're obligated to file a return depends on your filing status.
- For the 2016 tax year — the return you’ll file in 2017 — single taxpayers under age 65 don’t have to file a return if they earned less than $10,350 from a regular job and/or investments.
- If you’re age 65 or over, you have a little more room, up to $11,900 before you must file a return.
- If you qualify as head of household, the ceiling increases to $13,350 if you’re under 65 and $14,900 if you’re 65 or older.
- If you’re married filing jointly, the limit is $20,700 if both you and your spouse are under 65. This increases to $21,950 if one of you is 65 or older and to $23,200 if both of you are.
- If you’re married and filing separately, you can’t earn much at all before you’re required to file a return: $4,050 no matter how old you are.
The self-employment income threshold is always $400 as of the 2016 tax year, regardless of your filing status. If you earn this much from freelancing or running your own business, you must file a tax return.
You should receive a Form 1099-MISC from anyone who paid you over the course of the year. This $400 limit is an aggregate figure. In other words, if Joe paid you $290 and Sally paid you $110, you must file a return because these two payments total $400 when added together.
You Might Want to File Anyway
Before you say “Phew!” and put away your calculator, consider this. If your income falls within these parameters for your filing status, you may be entitled to claim the earned income tax credit, which is refundable. The Internal Revenue Service will send you money if the credit exceeds your tax liability — but only if you file a return to claim the credit.
Likewise, if you earned less than the limit for your filing status last year, you're not required to file a return but your employer almost certainly withheld income taxes from your paychecks. You can’t get a refund of that money unless you file.
What Tax Bracket Do You Fall Into?
Presuming that you do have to file, the next question becomes how much you have to pay.
Tax brackets confound a lot of taxpayers, so don’t feel alone if you’re a bit mystified by them. They determine the percentage of your income, after claiming various deductions, that you must give to the IRS.
Here’s how they breakdown for the 2017 tax year. This is the income you’ll file a return for in 2018.
- 10 percent: $0 to $9,325 in income
- 15 percent: $9,326 to $37,950
- 25 percent: $37,951 to $91,900
- 28 percent: $91,901 to $191,650
- 33 percent: $191,651 to $416,700
- 35 percent: $416,701 to $418,400
- 39.6 percent: $418,401 and over
Many people think they must pay this percentage on all their income, but that’s not accurate. If you have earned income of $37,000, you would pay just 10 percent in taxes on the first $9,325 of that — this portion falls in the 10 percent bracket. You would only pay 15 percent on income over that amount, the portion that falls within the next tax bracket. Likewise, if you earned $50,000, you would only pay at a 25 percent tax rate for the dollars you earned over $37,950.
Now You Can Deduct From That Income
You can claim dependents and take other deductions to reduce your income and potentially bring your income into a lower tax bracket. According to a Pew Research Center study, the average overall tax rate of American taxpayers who earned less than $50,000 in 2014 was just 4.3 percent after they made use of all available deductions.
One of the greatest deductions provided by the tax code is the personal exemption. As of the 2017 tax year, you can shave $4,050 off your taxable income for each dependent you can claim on your tax return in addition to yourself. At high-income levels — $261,500 for individuals, $287,650 for heads of household and $313,800 for married couples filing jointly — these personal exemption amounts begin to “phase out,” however. You’ll be entitled to claim less than the standard amount when your income surpasses these limits, and you might not be able to claim personal exemptions at all depending on how much more you earn.
Otherwise, if you earned $50,000 last year and you’re a single taxpayer without any dependents, your taxable income drops to $45,950 just like that.
Now, look what happens if you have a child. Your income drops by $8,100 — $4,050 times two. If you have two dependents, your income could drop by $12,150.
It’s no wonder that people wish they could claim their pets as dependents. Alas, it’s not that easy. Strict rules apply. First, your dependents must be human and there are different rules for child dependents and other relatives.
Qualifying Child Dependents
To qualify as your dependent, a child must:
- Be related to you, but this rule is applied loosely. Stepchildren and foster children qualify, as do half siblings.
- Be younger than age 19 on the last day of the tax year, or age 24 if he’s enrolled as a full-time student
- Be younger than you or, if you’re married and filing jointly, younger than either you or your spouse
- Live with you more than six months of the year
- Have for paid no more than half of his own support for the year
The age rule doesn’t apply to disabled children, and you might be able to claim a child who is not related to you under some isolated circumstances. Maybe you live with your girlfriend and you support her child. If she can’t claim her child as her own dependent for some reason, and if no one else can claim him either, there’s an outside chance that you could do so. Speak with a tax professional if you’re in a unique situation like this.
The IRS has a host of rules for adult dependents, too, such as if you support your elderly mother.
No age limits apply to qualifying relatives — the individual can even be a child, but minors can’t be anyone else’s “qualifying child.” This is the tax rule that might potentially allow you to claim your girlfriend's child. Some other rules apply as well.
- The individual must be related to you. Depending on how closely you’re related, she may have to live with you all year. A parent would not have to live with you.
- Her gross income for the year must be less than the amount of the personal exemption you want to claim for her, which is $4,050 in 2017.
- You must pay at least half of her total support.
Again, these are general rules, so if you find you’re skating a line where you think someone might be your dependent, check with a tax professional to be sure. If you claim someone you’re not entitled to claim, you may open yourself up for an audit.
The Standard Deduction
You're not done whittling away at your taxable income yet. There are still more deductions available to you. At the very least, you can probably subtract an additional $6,350 from your overall income to determine your tax bracket. This is the standard deduction for individual taxpayers and for those who are married but filing separately. The deduction doubles to $12,700 if you’re married and filing jointly, and it's $9,350 if you qualify as head of household.
If you’re single with one dependent, your $50,000 in earnings is now reduced to at least $35,550: $50,000 less the $8,100 for two personal exemptions less $6,350 for the standard deduction. But that dependent you’re claiming might very well qualify you as head of household, bringing you a total reduction in income of $17,450 — the $8,100 in personal exemptions plus $9,350. Your taxable income would be just $32,550.
Your other choice would be to itemize your deductions, but this may not be to your advantage. You add up all the tax-deductible expenses you paid over the course of the year when you itemize — and you should have proof of each of them, down to the penny. Deductible expenses include things like medical bills, charitable contributions, and property taxes. You would then deduct the total instead of the standard deduction.
Some expenses are subject to limitations, so it can be difficult to come up with more than the $9,350 standard deduction if you’re head of household, or even $6,350 if you’re a single taxpayer. And if you don’t have more tax-deductible expenses than the amount of the standard deduction you’re entitled to, you’ll pay taxes on more income than you have to. The majority of individual taxpayers — about 66 percent — claim the standard deduction.
Adjustments to Income
You may be able to take some deductions in addition to your standard deduction. These are called adjustments to income or “above the line” deductions, and you don't have to itemize to claim them. You can subtract them on the first page of your Form 1040 to determine your adjusted gross income. If you paid student loan interest, you can take that deduction here. Likewise, if you paid your ex-alimony, you can deduct that as an adjustment to income — you don’t have to pay taxes on this money. IRA contributions can also be deducted as an adjustment to income.
Now See If You Can Reduce Your Tax Bill
OK, you’re finished taking all the deductions you’re entitled to. Maybe you managed to chop that $50,000 income down to $31,000 thanks to personal exemptions, the standard deduction and the interest you paid on those student loans. But what if you find that you still owe the IRS $1,000 after all that subtracting?
This is where tax credits come in. A number of tax credits exist to help you eliminate this tax debt. The vast majority of them are non-refundable. This means they can reduce or even eliminate the balance you owe the IRS, but the IRS gets to keep the balance if any of the credit is left over. If you're eligible for a $2,000 credit but you only owe the IRS $1,000, the credit will erase your tax bill — you won't owe anything — and the government is $1,000 richer.
Refundable credits — like the earned income tax credit mentioned above — are much better. If you're eligible to claim any of these credits, the IRS will send you a check for the balance after your tax liability is reduced to zero. A $2,000 refundable credit would eliminate your tax debt and the IRS would give you the $1,000 balance.
Here are some of the most common tax credits you might be eligible to claim:
- Earned Income Tax Credit: The EITC is aimed at assisting low-income taxpayers with dependents. As of 2017, the maximum credit available is $6,318 if you’re married, if you file jointly, and if you have three or more dependents. Your income must fall below certain thresholds. The credit decreases as you earn more and is eventually unavailable entirely if you earn too much.
- American Opportunity Tax Credit: You can claim a credit of up to $2,500 per student as of 2017 for tuition and other education-related expenses incurred for the first four years of post-secondary education. Forty percent of this credit is refundable. This means you can get up to $1,000 back in cash if you’re entitled to the maximum $2,500 credit.
- Child and Dependent Care Credit: If you must pay someone to care for your child or another dependent so you can go out to work or look for work, you may be eligible for the child and dependent care tax credit. The child must be younger than age 13, and adult dependents must be disabled. You can also claim this credit if your spouse is disabled and someone must stay with him or her. Calculating the amount of the credit can be complicated, so you might need the help of a professional to figure it out. It's not refundable.
- Child Tax Credit: This one amounts to up to $1,000 for each of your child dependents under age 17, and you can claim it in addition to the credit for care expenses. It’s not refundable, but the Additional Child Tax Credit can kick in if you fall into the 10 percent tax bracket and this one is refundable. It works in tandem with the child tax credit to get you some cash back. The tax-bracket rule is new to the tax code effective January 2017.
There are also credits available for adoption, retirement savings and certain housing expenses. Some phase out at higher income levels.
What If You Can’t Pay?
After all is said and done, what happens if you still owe the IRS money and you just can’t lay your hands on the cash to send payment when you submit your return? The IRS is willing to work with you in a few ways:
- If you think you can pay within 120 days of filing your return, call the IRS at 1-800-829-1040 to make that arrangement.
- If you think it will take you longer to come up with the money, you may be eligible for an installment agreement so you can pay your tax debt in regular and equal monthly installments. There are some fees associated with this.
- If you’re really in dire straits, call the IRS — or better yet, consult with a tax professional — to see about entering into an offer in compromise. The rules are complex, but the IRS might be willing to accept just a portion of what you owe.