RPF-0053-Explanation_of_Structure_of_1040
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00:00:15.100 | Radical Personal Finance episode 53.
00:00:19.200 | How does my tax return work?
00:00:21.300 | Welcome to the Radical Personal Finance podcast.
00:00:40.100 | I thank you for being here with us today.
00:00:42.000 | Today is Wednesday, September the 3rd, 2014.
00:00:45.800 | My name is Joshua Sheets.
00:00:47.700 | I'm your host here with you today and every day peeling back the curtains of the financial world,
00:00:54.200 | introducing you to the concepts, information, inspiration, and education you need to get and stay rich.
00:01:09.900 | And when I say rich, I mean rich in every sense of the word.
00:01:12.600 | Rich in money, rich in life, rich in experiences, rich in relationships.
00:01:17.200 | I mean rich as it really is and should be designed.
00:01:21.000 | Today, I'm excited to talk to you about taxes.
00:01:25.000 | I'm going to say it again.
00:01:25.500 | I'm excited to talk to you about taxes.
00:01:30.600 | Yes, I'm excited to talk to you about taxes.
00:01:32.400 | I really am.
00:01:33.300 | And today we're going to walk through something that for some of you is going to sound incredibly basic and beginner's level.
00:01:42.800 | But I promise you there are many, many, many people who are going to benefit from this show.
00:01:49.000 | Today, I'm going to explain to you how your United States tax return form 1040 works.
00:01:57.900 | If you're listening to my show from another country, I would suggest, I mean, you can listen to this show,
00:02:02.300 | but you might want to skip it and go and read your own tax return for your company or for your country.
00:02:07.600 | But I'm going to talk through the US tax return.
00:02:10.300 | And the reason I'm going to do this is because, let me start with a story and this will tell you exactly why.
00:02:16.500 | I never understood how my tax return worked.
00:02:18.700 | I think I started filing tax returns when I was about 15 years old, maybe 14, I don't remember, but I had earned income.
00:02:25.000 | And so my dad said, "Okay, you know, you need to file your taxes."
00:02:28.200 | And so I sat down and I immediately did what everyone from my generation does, pulled up a computer program.
00:02:33.500 | And I pulled up a computer program, one of the online tax ones stuck in my W-2 and started calculating my taxes.
00:02:40.500 | And at that point in time, I didn't earn a lot of money, so I wound up getting money back, which was awesome.
00:02:44.900 | I was excited to get a refund.
00:02:46.400 | Then the next year, same thing.
00:02:47.800 | Then the next year, the same thing.
00:02:49.400 | Did this every year and I got very good at entering the data into a computer program.
00:02:54.100 | But I never understood what the data meant.
00:02:57.100 | Entering data into a computer program and knowing what the computer program does and how it works is a very different thing.
00:03:03.100 | So then I got out.
00:03:04.900 | This is so embarrassing, but I promise I'll never hold back from sharing the embarrassing stuff.
00:03:10.200 | So I got out and I started working as a financial advisor.
00:03:12.700 | So I'm out there and I start looking at tax returns and I realize I don't have a clue how to read a tax return.
00:03:20.100 | I had a client.
00:03:20.700 | The client would give me a tax return and I would sit there and I would look at it and I would try to look smart and I would recognize I don't have a clue what to look at on this thing.
00:03:29.300 | And then I learned I'm not the only guy.
00:03:31.000 | I'm not the only one to whom this happens.
00:03:33.700 | There are lots of other people.
00:03:35.300 | One of my favorite questions to ask people is simply how much did you pay in income taxes last year?
00:03:41.800 | And I would estimate that 85% of the time, the answer I get back when I ask that question, I ask how much did you pay in income taxes last year?
00:03:50.400 | And the answer I get is, again, 85% of the time, is, oh, I got a refund.
00:03:55.600 | I got about a $3,000 refund.
00:03:58.900 | That's not my question.
00:03:59.900 | I didn't ask how big your refund was.
00:04:01.500 | I asked how much did you pay in income taxes.
00:04:06.100 | And so then I would say, well, oh, I don't know.
00:04:08.800 | I would ask the question again.
00:04:09.700 | People say, I don't know.
00:04:11.200 | Then I realized we have an epidemic of taxpayers that don't know how to read their tax returns and I was the king of that because I did that.
00:04:17.200 | So I said, I got to learn this, which, by the way, if I ever ask you that question, if I ever ask you how much money did you pay in your income taxes, all you need to do, very simple,
00:04:27.000 | go to line 61 of your tax return.
00:04:31.900 | Line 61 says this is your total tax.
00:04:36.100 | That's the number that you want to calculate.
00:04:38.700 | You want to look at that number and you want to assess that number and then you want to express it as an equation of your total tax as compared to your total income.
00:04:48.300 | But that was another day's show.
00:04:50.000 | So that's the answer.
00:04:51.400 | Go to line 61 of your tax return and look at what is your total tax.
00:04:54.600 | That will tell you how much money you're paying in taxes.
00:04:58.700 | So I was so embarrassed by that I said, I got to learn how to read a tax return.
00:05:04.900 | So I started researching this stuff and I recognized, like, we're never taught how to do taxes.
00:05:09.400 | Now, I found a few people.
00:05:10.600 | The people, you know who I found who does know the answer?
00:05:13.100 | The people who do their taxes by hand.
00:05:15.300 | I couldn't conceive of how you could do this.
00:05:18.100 | I still have some friends that do their taxes by hand.
00:05:21.100 | And now I look at it and I say, wow, I wish that at 15 my dad had sat me down with a form and taught me how to do it by hand.
00:05:29.000 | But he didn't do his by hand.
00:05:30.400 | He used a software solution as well.
00:05:33.000 | So I'm sure he has in the past.
00:05:35.700 | But that's my tax story.
00:05:37.200 | So today I'm going to explain to you how your tax return works.
00:05:40.700 | And this is designed to be a broad base -- a broad approach to the education.
00:05:49.000 | And I'm using this as a foundation for future very detailed persnickety little tax ideas that I'm going to develop for you.
00:05:57.700 | But if when I talk about an exemption or a deduction or an exclusion or a credit, if you don't understand what those words mean, it's hard to process that information.
00:06:05.400 | So today I'm going to explain the tax formula for you.
00:06:10.000 | So let's start there.
00:06:11.600 | Tax -- individual income tax formula for the United States of America.
00:06:15.300 | Again, this is the individual income tax formula.
00:06:18.800 | What we do is we take a number that's called our gross income.
00:06:22.700 | Gross income.
00:06:25.800 | That's where we start.
00:06:26.500 | Gross income.
00:06:27.100 | And I'll define all these terms in just a minute.
00:06:28.800 | Gross income minus our four AGI deductions.
00:06:34.100 | AGI stands for adjusted gross income, which is coming next.
00:06:37.700 | So gross income minus our four AGI deductions equals our adjusted gross income.
00:06:44.700 | Adjusted gross income minus from AGI deductions.
00:06:51.000 | And the greater of -- excuse me.
00:06:56.800 | Gross income -- see, even I can't even get through it.
00:07:00.000 | Gross income minus the four AGI deductions equals our adjusted gross income.
00:07:04.200 | Then we subtract our from AGI deductions.
00:07:07.800 | And there are two of these.
00:07:09.100 | Two sets of them.
00:07:10.200 | The greater of either the standard deduction or the itemized deduction and our personal and dependency exemptions equals our taxable income.
00:07:23.500 | So, again, we take our adjusted gross income minus our from AGI deductions.
00:07:29.000 | And those from AGI deductions are either our standard or itemized deductions.
00:07:33.000 | And then our personal and dependency exemptions equals our taxable income.
00:07:37.800 | Taxable income times the tax rates equals our income tax liability.
00:07:45.500 | Plus other taxes due equals our total tax.
00:07:51.700 | Our total tax minus our tax credits minus our tax prepayments equals the taxes due to the government or refund due from the government.
00:08:05.500 | I know that was a lot.
00:08:07.800 | But that's the formula that you need to understand.
00:08:10.300 | And I'm going to break it down and make it really simple.
00:08:12.200 | But each of those numbers and each of those words is important.
00:08:16.100 | Now, with tax planning, people often say, Joshua, how do I save money on taxes?
00:08:18.900 | It's not one thing.
00:08:20.400 | I am not aware.
00:08:22.000 | If you are, you can call me, email me, Joshua@radicalpersonalfinance.com.
00:08:25.700 | And email me.
00:08:27.400 | If you know of one thing that everyone can do to save money on their taxes that's legal, that's not evasion, let me know.
00:08:35.100 | And I'll have you on the show to teach it.
00:08:36.900 | But I have never been able to find it.
00:08:38.600 | Rather, good tax planning is a whole bunch of things put together.
00:08:42.200 | And you need to start by understanding the income tax formula.
00:08:45.400 | Because once you understand the formula, you can then understand how to adjust every aspect of the formula.
00:08:52.200 | So good tax planning happens prior to gross income.
00:08:55.200 | It happens in our for AGI deductions.
00:08:57.700 | It happens in our from AGI deductions.
00:08:59.700 | It happens in itemized deductions.
00:09:01.200 | Figuring out how to increase our dependency exemptions.
00:09:03.700 | And understanding, okay, what is a dependent, what is not a dependent.
00:09:06.700 | It equals a lot of things.
00:09:10.200 | Taking credits.
00:09:11.700 | Minimizing our other taxes.
00:09:14.200 | Minimizing our AMT.
00:09:15.700 | Minimizing our self-employment taxes.
00:09:17.700 | So it comes from understanding it.
00:09:19.200 | So let me read the formula again.
00:09:20.700 | Gross income minus for AGI deductions equals adjusted gross income.
00:09:24.700 | Adjusted gross income minus from AGI deductions, which are either our standard or itemized deductions, and our personal and dependency exemptions,
00:09:32.700 | equals our taxable income.
00:09:34.700 | Taxable income times the tax rates equals our income tax liability.
00:09:39.700 | Income tax liability plus other taxes equals total tax.
00:09:43.700 | Minus the credits minus the prepayments equals the taxes due or the refunds.
00:09:48.700 | So we're going to walk through that formula.
00:09:50.200 | Let's start by defining our terms.
00:09:52.200 | Good little classical education tip.
00:09:54.200 | Start with grammar.
00:09:55.700 | Grammar is defining your terms.
00:09:57.700 | Something we don't do enough in our education.
00:09:59.700 | The classical education is often used as the trivium.
00:10:02.700 | Trivium is grammar, logic, and rhetoric.
00:10:04.700 | We always start with grammar.
00:10:06.700 | So let's define our terms.
00:10:08.700 | Gross income.
00:10:11.700 | The U.S. tax law is based upon the all-inclusive income concept.
00:10:20.700 | What that means is that your gross income includes all realized income from whatever source derived.
00:10:29.700 | Now notice how all these little words are.
00:10:32.700 | Realized income.
00:10:33.700 | Realized income is income that is generated in a transaction with a second party in which there is a measurable change in property rights between the parties.
00:10:44.700 | So there has to be an actual transaction in this example in order for there to be realized income.
00:10:51.700 | There's a difference between realized income and then recognized income and some of these words.
00:10:55.700 | But that's what realized income is.
00:10:57.700 | So there has to be an actual transaction that occurs to have income.
00:11:06.700 | Now gross income means all income.
00:11:09.700 | All income period.
00:11:11.700 | That's all you need to know.
00:11:13.700 | But let's walk through a list because there are a lot of misconceptions about what all income includes.
00:11:19.700 | I'm going to go into this in detail because I think it's important that you know.
00:11:24.700 | All income includes any compensation for services, including any fees or commissions or any other form of compensation.
00:11:31.700 | It includes the gross income derived from business, the gains derived from dealings in property, any interest received, any rents received, any royalties received,
00:11:42.700 | any dividends received, alimony and separate maintenance payments, any annuities or annuity income received, any income from life insurance and endowment contracts,
00:11:52.700 | any pensions, any income from the discharge of indebtedness, any distributive share of partnership income, any income in respect of a decedent.
00:12:02.700 | That's income that you get after your death, income with respect to the decedent, IRD.
00:12:07.700 | Income from an interest in an estate or trust and any unemployment compensation.
00:12:13.700 | Now I can hear those of you who are tax nerds already saying, "Wait a second, wait a second. What about that? What about, you know, listen, I always heard, let's go with the easy one.
00:12:20.700 | Income from life insurance payments is not taxable."
00:12:23.700 | That is correct. It is an exclusion, which we will cover in detail, all of the exclusions, but still it's technically included as gross income.
00:12:33.700 | Everything you receive for any kind of service must be included in your gross income.
00:12:41.700 | Income has been defined in a Supreme Court case as "undeniable accession to wealth clearly realized over which the taxpayers have complete dominion."
00:12:55.700 | Now you'll recognize, if you are an astute student, you will recognize from tax planning show number 41, which was the last one in this tax series, where we talked about the IRS doctrine of constructive receipt.
00:13:11.700 | So the Supreme Court case says, "Income is defined as undeniable accession to wealth clearly realized over which the taxpayers have complete dominion."
00:13:24.700 | And so the IRS then developed the constructive receipt doctrine, which says that you have it when there is no longer a substantial risk of forfeiture of the money.
00:13:35.700 | I'm going to read a text, one paragraph here from the--I'm going to read one paragraph from the IRS regulation from Wikipedia under the constructive receipt entry.
00:13:44.700 | "Income, although not actually reduced to a taxpayer's possession, is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time,
00:14:00.700 | or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given.
00:14:06.700 | However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions."
00:14:15.700 | Here's why this is important, why I'm trying to build these step by step.
00:14:19.700 | That's important because later when we get to designing--when we talk through how do you design a deferred compensation program,
00:14:26.700 | it's important that in order to defer the tax on compensation, the person to whom that--the person--the person who is entitled to receive that compensation must continue to face what's called a substantial risk of forfeiture.
00:14:44.700 | They must not constructively receive the money, they must still be under a substantial risk of forfeiture if they are going to be able to--if they're going to be able to defer the tax.
00:14:57.700 | This is how--these doctrines are what all of the tax planning ideas are built upon.
00:15:02.700 | So, some tax planning ideas, something as simple as an IRA, is built upon a specific codified law that allows the deduction for that income.
00:15:16.700 | But many of the more advanced tax planning techniques are built upon this doctrine, the doctrine of constructive receipt, must be a substantial risk of forfeiture, etc.
00:15:26.700 | So, gross income includes basically all money.
00:15:32.700 | Now, I'm going to hammer this home just with a few more ideas.
00:15:36.700 | That's all money, so wages, salaries, commissions, tips, and fees.
00:15:40.700 | Any money that you receive, tips of any kind, any amounts that are withheld from your pay for income or social security taxes are considered received by you and must be included in your income.
00:15:52.700 | Any amounts withheld for insurance or union dues, that's income.
00:15:57.700 | If your employer uses your wages to pay your debt, or if the wages are attached or garnished, the full amount of that money is income.
00:16:07.700 | Any vacation allowances paid to you from a vacation fund or wages, that must be included.
00:16:12.700 | Severance pay, taxable income, must be included.
00:16:15.700 | Any lump sum payment for cancellation of an employment contract is income.
00:16:19.700 | Any rewards or bonuses, any prizes, including in all expenses paid vacation.
00:16:25.700 | For example, if you're a salesperson and if you won a prize, if you won a prize on a TV game show, all prizes, everything is included as income.
00:16:35.700 | If you buy property from your employer at a reduced price, then you have to include in your income the excess of the property's fair market value over what you paid for it.
00:16:43.700 | You have to include that discount that you received from an employer.
00:16:48.700 | If you receive a cash allowance from your employer for meals or lodging, you need to include that cash allowance in your income.
00:16:55.700 | Any interest you receive from a bank, the fair market value of any gifts or services received as inducement to open the bank account.
00:17:07.700 | Any amounts you receive as rental income must be included.
00:17:11.700 | Any fees for service for service of any kind, for example, if you serve on a jury, as a notary public, as an executor or administrator of an estate, as a corporate director,
00:17:21.700 | as an election precinct official, as an accountant, an attorney, a medical practitioner, any wages of any kind.
00:17:28.700 | That's gross income.
00:17:30.700 | Income that you receive in the form of property or services must be included in income as its fair market value on the dates received.
00:17:39.700 | So let's assume that you set up a barter arrangement with somebody where you are transacting with property or services rendered.
00:17:46.700 | That must be included in your gross income.
00:17:49.700 | And any dividends, capital gains, distributions, gains on the sale of property, all of that is included in gross income.
00:17:57.700 | Everything is included in your gross income.
00:18:04.700 | All accessions to wealth clearly realized over which you have dominion.
00:18:09.700 | Again, to quote the Supreme Court.
00:18:14.700 | Pretty onerous, huh?
00:18:17.700 | I don't know about you, but I always get a little bit annoyed by that.
00:18:20.700 | Nothing you do by which you realize any economic gain, there's nothing that you can do by which you realize any economic gain that can be ignored in that calculation.
00:18:35.700 | Now, there are specific exclusions, and we will go through those exclusions in detail in a future show, because there are some very interesting exclusions.
00:18:47.700 | And you need to find some of those interesting exclusions, the ones that apply to you if you're going to do effective tax planning.
00:18:53.700 | There are exclusions, but if you have any gain of any kind, that counts as income.
00:18:59.700 | Just remember that.
00:19:01.700 | And vote.
00:19:04.700 | So let's go back to our formula.
00:19:07.700 | What about gross income?
00:19:09.700 | Let's go through some of the exclusions.
00:19:11.700 | So, realized income that you can permanently exclude from taxation is an exclusion.
00:19:21.700 | Any realized income that you can include in gross income in a subsequent year is called a deferral.
00:19:28.700 | Reading here from one of my financial planning textbooks.
00:19:31.700 | We'll go through deferrals in a minute.
00:19:33.700 | Let's start with exclusions.
00:19:35.700 | So what are some common exclusions?
00:19:37.700 | Well, what about the most famous of tax shelters, municipal bonds?
00:19:46.700 | Interest income from municipal bonds is excluded from federal income taxation.
00:19:52.700 | Any gifts or inheritances, excluded.
00:19:58.700 | Remember, gifts and inheritances will function based upon the estate tax, the transfer tax laws, not under the income tax laws.
00:20:05.700 | Those are excluded.
00:20:06.700 | The gain on a sale of a personal residence, that's excluded.
00:20:09.700 | Certain conditions on that.
00:20:11.700 | Life insurance proceeds.
00:20:14.700 | Your grandfather dies, leaves you a million dollar life insurance benefit.
00:20:18.700 | Those life insurance proceeds are excluded.
00:20:23.700 | An installment sale is a deferral, and a like-kind exchange is a deferral.
00:20:28.700 | So if you make an installment sale on a business, you can defer the income to a future year.
00:20:35.700 | If you do, for example, either a 1031 exchange or a 1035 exchange, whether that's for real estate or for insurance policies and annuities,
00:20:45.700 | then that will allow you to do -- those are like-kind exchanges.
00:20:51.700 | And technically, you may be interested to know, they're not limited to real estate.
00:20:55.700 | The rules under Section 1031 of the Internal Revenue Code are not just about real estate.
00:21:02.700 | They are what's called a like-kind exchange.
00:21:06.700 | So those are the two -- you'll often hear, "Oh, there's a 1031 exchange."
00:21:10.700 | That's where you are selling one piece of property and transferring the value of that property into a new piece of like-kind property
00:21:18.700 | so that you can defer recognizing the income on that capital gain, if you have a capital gain.
00:21:27.700 | That would be the reason you did it.
00:21:29.700 | If you didn't have a capital gain, you wouldn't do a like-kind exchange.
00:21:33.700 | So a 1031 exchange could be used for any kind of property.
00:21:37.700 | It could be used for equipment for equipment.
00:21:39.700 | It could be used for any kind of like property that would be a capital gain asset.
00:21:47.700 | And, again, go through the code under Section 1031.
00:21:53.700 | I have to be careful when doing tax planning with these words.
00:21:55.700 | It could be any kind of property.
00:21:56.700 | It's not true.
00:21:57.700 | Read the tax code, if you can, or read the articles about the tax code.
00:22:02.700 | But my point was that it's not just about real estate.
00:22:04.700 | That's where it's most common.
00:22:06.700 | 1035 exchanges are the exchanges of annuity contracts for annuity contracts,
00:22:10.700 | or life insurance contracts for life insurance contracts,
00:22:12.700 | or life insurance contracts for annuity contracts,
00:22:15.700 | where you can defer the gain that is inside the insurance contract.
00:22:22.700 | Someday we'll do a show on what's called "boot," one of the most fun things.
00:22:28.700 | If you're a CFP student, you will need on the CFP exam to do a boot calculation,
00:22:34.700 | or there will be some question about it.
00:22:36.700 | So a boot would be called -- if you have a 1031 exchange, a like-kind exchange,
00:22:42.700 | but there's some amount of additional compensation --
00:22:45.700 | let's just say money is exchanged as part of that because the property values are not equal --
00:22:49.700 | then you've got to figure out the taxation on the boot.
00:22:51.700 | So who has the boot? That's how you answer those questions.
00:22:54.700 | Going on, continuing on, and not letting myself get too distracted.
00:22:57.700 | Those would be some common exclusions and deferrals.
00:23:00.700 | Now, it is important to know that gross income doesn't denote what kind of income we have.
00:23:09.700 | So that would be referred to as the character of income.
00:23:12.700 | There are a few different ways that income can be characterized.
00:23:15.700 | It could be characterized as tax-exempt income.
00:23:18.700 | It could be referred to as tax-deferred income.
00:23:20.700 | It could be ordinary income.
00:23:23.700 | It could be a qualified dividend.
00:23:29.700 | Any of those are doable.
00:23:30.700 | Or it could be capital income.
00:23:33.700 | So those are the categories that you need to think about, and that would matter.
00:23:37.700 | So one of the things -- let's talk about tax planning 101.
00:23:39.700 | One of the things we want to do, we want to move money that's going to be potentially taxed
00:23:45.700 | at a rate that we don't want into a preferentially taxed rate.
00:23:48.700 | So a simple example, if we can move money from ordinary income over into qualified dividend income,
00:23:54.700 | that will save us money.
00:23:56.700 | That's why you have the whole stupid thing where Warren Buffett says,
00:23:58.700 | "I don't pay as much tax as my secretary," because your income is dividend income
00:24:02.700 | and her income is ordinary income.
00:24:04.700 | Warren Buffett pays himself, I think, a buck a year or $100,000 or something like that,
00:24:08.700 | and then the balance is all investment income, and it's preferentially taxed.
00:24:12.700 | We'll ignore the political conversation for today.
00:24:18.700 | So that's gross income.
00:24:21.700 | Let's talk about deductions.
00:24:22.700 | So we have our gross income.
00:24:23.700 | Then we have our four AGI deductions, and the deductions are things that are specifically legislated.
00:24:33.700 | So there is a complete list of deductions.
00:24:35.700 | I will go over them at another time.
00:24:38.700 | But they are specifically granted by law.
00:24:41.700 | And there's four AGI deductions, and there are from AGI deductions.
00:24:45.700 | So that adjusted gross income number is important because there are many places in the formulas
00:24:50.700 | where that adjusted gross income number is used.
00:24:53.700 | So what's better is to have a for AGI deduction.
00:24:59.700 | What's good but not the best is to have a from AGI deduction.
00:25:02.700 | These will also be called, if you're talking with an accountant,
00:25:05.700 | this will also be called an above-the-line deduction and a below-the-line deduction.
00:25:08.700 | The reason it's called that or a front-page deduction or back of the--what do they say?
00:25:14.700 | I don't even remember.
00:25:15.700 | Front of the form, back of the form.
00:25:17.700 | The reason is because at the very bottom of the front page of Form 1040 is line 37.
00:25:21.700 | That's your adjusted gross income.
00:25:23.700 | So above that line at the bottom of the first page, those are for AGI deductions,
00:25:27.700 | and below that line is from AGI deductions.
00:25:31.700 | For AGI deductions are usually things that are going to be associated with business activities
00:25:38.700 | and some investing activities.
00:25:41.700 | These are better.
00:25:42.700 | These are the better ones.
00:25:44.700 | So examples here would be--you'll see specifically it's lines 23 through 36 on your--excuse me,
00:25:50.700 | lines 23 through 35 on your form.
00:25:53.700 | This would include alimony paid, health insurance deduction for self-employed taxpayers,
00:25:58.700 | moving expenses, rental and royalty expenses, one-half of self-employment taxes paid,
00:26:04.700 | business expenses, losses on the disposition of assets used in a trade or business,
00:26:09.700 | and capital losses.
00:26:11.700 | Net losses are limited to $3,000 for a year.
00:26:13.700 | The rest of them have to be carried forward.
00:26:16.700 | And then contributions to qualified retirement accounts.
00:26:19.700 | So those are all your four AGI deductions.
00:26:23.700 | So when you take an IRA deduction, it's line 32.
00:26:26.700 | That's a four AGI deduction.
00:26:28.700 | When you take an alimony deduction for alimony paid, that's line 31.
00:26:32.700 | That's a four AGI deduction.
00:26:34.700 | You get the point.
00:26:36.700 | But any four AGI deduction that you can take--line 25, a health savings account deduction--
00:26:42.700 | any four AGI deduction that you can take, that's going to be superior
00:26:47.700 | because it will allow and open up some of the other formulas to work a little bit better
00:26:51.700 | because the four AGI deduction will be lower.
00:26:54.700 | The example here would be--the example that I would use would be something like the 7.5%--
00:27:00.700 | no, they just changed it.
00:27:02.700 | It's 10%--10.5%?
00:27:04.700 | Just a moment.
00:27:06.700 | IRS.gov, 10%.
00:27:08.700 | So it was a 7.5% deduction for medical expenses.
00:27:12.700 | If your medical expenses exceeded 7.5% of your adjusted gross income,
00:27:16.700 | you were allowed to take that under the deduction section later on.
00:27:20.700 | Now it's 10%.
00:27:22.700 | Well, if you have $100,000 of adjusted gross income,
00:27:25.700 | then your medical expenses would have to exceed $10,000 for you to be able to use that deduction.
00:27:32.700 | But if you had, let's say, $90,000, then your medical expenses would only have to exceed $9,000.
00:27:39.700 | Now, obviously, small difference, but all these little things matter.
00:27:43.700 | We're going with the academic approach today to kind of walk through them all.
00:27:46.700 | You have to put each of these things together in your world based upon what will actually make sense to you.
00:27:52.700 | Next we have your from AGI deductions, your below-the-line deductions.
00:27:57.700 | This would include any itemized deductions or the standard deduction and your exemption.
00:28:04.700 | So the standard deduction is fairly simple.
00:28:06.700 | It's written right on the form, right on the left-hand side.
00:28:09.700 | Standard deduction says based upon your filing status, which will be another show,
00:28:13.700 | are you single or are you married filing separately, you get a certain deduction.
00:28:16.700 | Are you married filing jointly or qualifying widower, you get a high widower/widower, you get a higher deduction.
00:28:22.700 | And if you're head of household, you get an in-between deduction for your standard deduction.
00:28:26.700 | Your itemized deductions are what most people think about when they think of their deductions.
00:28:30.700 | This would include any medical and dental expenses, those that are deductible if they exceed 10% of AGI.
00:28:36.700 | Any taxes, so state or local income taxes, real estate taxes, personal property taxes.
00:28:42.700 | Any other taxes.
00:28:44.700 | Interest expense, so your mortgage interest expense, home equity interest expense, investment interest expense.
00:28:49.700 | Any gifts to charity.
00:28:51.700 | Any casualty or theft losses, deductible if they exceed a certain amount of AGI.
00:28:56.700 | Job expenses and some other miscellaneous deductions if they exceed 2% of AGI.
00:29:02.700 | And then other miscellaneous deductions such as gambling losses.
00:29:06.700 | So there are other deductions available.
00:29:09.700 | Those are all from AGI deductions.
00:29:12.700 | So then what you would do is after calculating your itemized deduction,
00:29:15.700 | you compare your itemized deduction to your standard deduction.
00:29:18.700 | Whichever is greater, then that's the number that you subtract on that form.
00:29:25.700 | You may be interested to know what percentage of people will use the standard deduction versus the itemized deduction.
00:29:31.700 | I found one estimate from the Tax Policy Institute where they estimated that about 70% of taxpayers claim the standard deduction.
00:29:38.700 | So where this is interesting is just from a personal finance perspective,
00:29:43.700 | all the hoopla that many people make about things like mortgage interest deduction.
00:29:48.700 | Most taxpayers don't use the mortgage interest deduction.
00:29:52.700 | Now the National Association of Realtors is not about to let it go away, which they would.
00:29:56.700 | But most people don't use it.
00:30:01.700 | The majority of people just simply use the standard deduction.
00:30:04.700 | You can run some numbers to figure out how big of a house,
00:30:12.700 | but most people just simply don't pay that much in interest, especially with today's low rates.
00:30:16.700 | That's been a big change.
00:30:18.700 | There's a big difference between the amount of interest that you pay at a 5% interest rate versus a 12% interest rate, obviously.
00:30:24.700 | The other from AGI deduction is the deduction for exemptions.
00:30:28.700 | An exemption is a flat deduction which is allowed for you, the taxpayer, your spouse,
00:30:36.700 | and each person who qualifies as a dependent for you, the taxpayer.
00:30:41.700 | The exemptions for the taxpayer are called personal exemptions,
00:30:48.700 | and the other ones are called dependency exemptions.
00:30:50.700 | We'll go through the dependency qualifications in another show.
00:30:54.700 | We won't have time for today.
00:30:55.700 | But a dependent doesn't necessarily have to be children, although often are.
00:31:00.700 | But there can be other dependents in your household.
00:31:04.700 | Back to our formula.
00:31:06.700 | We had our gross income minus our for AGI deductions equals our adjusted gross income.
00:31:10.700 | Then we took care of our from AGI deductions, and that equals our taxable income.
00:31:15.700 | Once we figured out our taxable income, then we go and we run it.
00:31:19.700 | We run either using the tax rates or, more commonly, we use the tax table.
00:31:24.700 | Most people, their software just spits it out, but we can go pull the IRS tax table,
00:31:28.700 | and the IRS tax table will show us what we actually need to pay to really the specific dollar amount.
00:31:35.700 | Now, be careful when you're doing that because the tax tables will often not necessarily reflect the character of income.
00:31:44.700 | So if we have different--let's say that your income is primarily dividend income.
00:31:49.700 | You need to be careful and calculate that carefully.
00:31:54.700 | But most people are going to use the tax tables.
00:31:58.700 | If we go on, then the next one, taxable income times the tax rates equals our income tax liability plus other taxes.
00:32:07.700 | What do I mean by other taxes?
00:32:08.700 | Well, other taxes would be things like the alternative minimum tax, the AMT.
00:32:13.700 | The AMT is a topic for another day in detail.
00:32:16.700 | But basically, you go back and you take out a bunch of the deductions and recalculate your whole tax bill without some of the deductions that are excluded.
00:32:26.700 | And then whichever bill is higher with the AMT formula, you pay that.
00:32:30.700 | But if you owe AMT, then this is where you add the AMT on to your tax liability.
00:32:37.700 | Or if you have things like self-employment taxes, let's say that you're running a personally owned business,
00:32:42.700 | and that's where you would go ahead and pay your self-employment taxes.
00:32:45.700 | It's all lumped in, it's sent in.
00:32:47.700 | Even though it's a separate tax, it's included on your form.
00:32:50.700 | Then we take our tax credits, so our income tax liability plus the other taxes equals the total tax.
00:32:55.700 | And then we subtract our tax credits.
00:33:00.700 | The cool thing about tax credits is they reduce the tax owed dollar for dollar.
00:33:09.700 | So the deductions that we took earlier, the deductions reduce the tax at whatever rate we're paying taxes at.
00:33:19.700 | So let's say that you had a dollar of a deduction and you're paying tax at, let's just say a 28% rate.
00:33:24.700 | Well, that means that you saved, for every dollar that you took in a deduction, you saved 28 cents.
00:33:29.700 | So the example here, if you paid a dollar to the mortgage company, let's say you're itemizing your deductions for mortgage interest indebtedness.
00:33:36.700 | If you pay a dollar to the mortgage company for your interest expense on your mortgage and you're in a 28% bracket,
00:33:43.700 | that saves you 28 cents that you don't have to send to the IRS.
00:33:48.700 | That's different than a tax credit.
00:33:50.700 | So a tax credit means that if they say you owe a dollar of tax and you have a $1 tax credit,
00:33:55.700 | then you can directly reduce the tax.
00:34:00.700 | Now, unfortunately, these are limited, but if you can get them, they're pretty cool.
00:34:06.700 | So this would include your child tax credit, the child and dependent care credit, the earned income credit,
00:34:12.700 | the American opportunity credit, and the lifetime learning credit are the most common.
00:34:20.700 | Then you subtract out any prepayments.
00:34:22.700 | That's where if you are self-employed or you own a business, you paid your quarterly taxes,
00:34:27.700 | because if you didn't, you're going to get penalized, and if you are employed,
00:34:30.700 | your employer withheld your taxes from each of your paychecks and they sent those in.
00:34:36.700 | So any of those withholdings that your employer did or your estimated tax payments,
00:34:42.700 | and then also any taxes that you overpaid in a previous year and then you told the IRS to hang on to until the next year,
00:34:48.700 | that would be included as a prepayment.
00:34:52.700 | And that equals your taxes due.
00:34:54.700 | And then if you overpaid and sent too much money to the IRS,
00:34:57.700 | then you are in a situation where you will receive a tax refund.
00:35:04.700 | Now, the topic of tax refunds, this is a pretty charged one.
00:35:08.700 | Some people love getting a tax refund, and the financial nerd in me hates to see that.
00:35:15.700 | I hate to see the government get any more free money than --
00:35:19.700 | they get your money, they don't pay you interest, but hey, if you underpaid --
00:35:22.700 | if you underpaid substantially, by the way, you're getting a penalty.
00:35:25.700 | So I hate to see the government get it, but I do get it that a lot of people, it works for them.
00:35:30.700 | They have a certain amount more withheld, and then they get an unexpected budget.
00:35:35.700 | They get an unexpected check that they didn't factor into their budget.
00:35:38.700 | So who am I to say what someone else should do or not do?
00:35:44.700 | So that's how your tax return works.
00:35:46.700 | This is all relatively straightforward if you look at the form.
00:35:49.700 | And I'm just sitting here looking at a Form 1040 that I've got here.
00:35:53.700 | I grabbed it from the library. I keep it around for handy purposes.
00:35:57.700 | And it's fairly straightforward if you actually look at the form.
00:36:01.700 | But we don't look at the form anymore, and this is the problem.
00:36:05.700 | I don't know the statistics on this, but one of the things that I think any of us could do
00:36:11.700 | that would really help is calculate your taxes by hand.
00:36:15.700 | Now, there are certain problems with that, but if you calculated them by hand,
00:36:19.700 | you would have a much better idea of how they worked.
00:36:22.700 | And I'm telling you, there's nobody, no young people that I know can actually understand
00:36:26.700 | how the formula works.
00:36:27.700 | Hopefully this will help you to understand how it works.
00:36:29.700 | Now, how do we save on taxes?
00:36:31.700 | Well, as you can see from the way that this works, there are different savings at each level,
00:36:39.700 | and they're all important.
00:36:41.700 | So the gross income calculation, for example.
00:36:44.700 | Well, we want to make sure that we have to include all of our income,
00:36:50.700 | but we only pay--let's say we own a business--we only pay tax on profit.
00:36:57.700 | So if we can convert an expense that's usually a personal expense over into a business expense,
00:37:07.700 | then that will allow us to defer the tax on the money that we would have had to spend on that.
00:37:12.700 | I basically think there are two tax codes.
00:37:15.700 | There's a business tax code and a personal tax code.
00:37:17.700 | Now, the IRS doesn't like me to say that, but really there is.
00:37:21.700 | People always talk about tax loopholes and all this stuff.
00:37:25.700 | I'm a layperson. I'm an amateur when it comes to taxes.
00:37:27.700 | But I tell you, I can't find that they exist.
00:37:30.700 | Every single person has the same tax code,
00:37:33.700 | but the business tax code and the personal tax code work differently.
00:37:37.700 | So that's why I think everybody--just being self-employed really does bring with it a lot more opportunities for tax savings
00:37:44.700 | because it allows you to convert some of your current activities.
00:37:47.700 | Let's say you can go over and take advantage of some of the exclusions.
00:37:51.700 | So, for example, if you own a business, you can set up a group life insurance plan,
00:37:57.700 | and you can exclude the cost on $50,000 of your life insurance.
00:38:01.700 | Is that going to make a big difference? Nah, not much.
00:38:04.700 | It's not much money.
00:38:06.700 | But it is one thing that you could do.
00:38:08.700 | You could set up--what would be a good example?
00:38:14.700 | I guess the example that comes to mind would be the little trick with carpool receipts.
00:38:19.700 | So one simple thing you can do is the money that you receive that's a reimbursement for the costs of running a carpool
00:38:26.700 | is money that is an excluded item from income.
00:38:31.700 | So if you--let's say that you have a lengthy commute,
00:38:35.700 | and you're an employee and you have a lengthy commute--it doesn't matter, actually.
00:38:38.700 | It could be a business owner, too, because you can't deduct personal commuting expenses as a business owner.
00:38:42.700 | But let's just assume for the sake of simplicity you're an employee, you have a commute,
00:38:46.700 | and your commute is costing--you have a 50-mile commute.
00:38:49.700 | Well, if you can set up some--and you're paying that every day, well, that's a non-deductible expense.
00:38:54.700 | Every single day--let me give my--here, 20 miles, and let's just say it's costing you 50 cents a mile.
00:39:01.700 | So if you're commuting 20 miles in and it's costing you 50 cents a mile, that's $10 for every 20 miles.
00:39:07.700 | So 20 miles into work, 20 miles out to work, that's 20 bucks a day of expenses over the--using the IRS.
00:39:13.700 | I think they're up to almost 60 cents now on the tax table.
00:39:15.700 | I don't remember. I haven't checked it for this year.
00:39:17.700 | But it's a lot of money that you're spending.
00:39:20.700 | Well, if that's $20 a day, then--let's multiply that. Let's go times 200.
00:39:27.700 | So that's $4,000 over the course of the year that you're spending on commuting expenses.
00:39:31.700 | And that's $4,000 that you have to earn, pay tax on, and then--so you have to earn it, pay tax on that money,
00:39:40.700 | and then cover that $4,000.
00:39:42.700 | Well, one little trick, if you can set up a carpool--let's say that you can set up a carpool with two of your coworkers
00:39:48.700 | and you can arrange it that they can cover you--they can pay you a sufficient amount to cover the cost of operating the vehicle,
00:39:57.700 | so covering the cost of your repairs, your gasoline costs, any other expenses that are associated with operating the vehicle.
00:40:04.700 | And that can be good for them if you have multiple people because it saves them money.
00:40:07.700 | Well, if you could--let's say that they were costing you $4,000, and if you could recoup $4,000 of expense,
00:40:14.700 | frankly, you could have your car expenses paid for, and now you have $4,000 of, essentially, income that is not taxed.
00:40:26.700 | So you convert that non-deductible expense into a tax-free expense where you are not paying tax on the cost.
00:40:36.700 | Is that going to save you--is that little trick going to save you a ton of money?
00:40:39.700 | No, it's not. But maybe for one or two of you, that would be an option.
00:40:44.700 | It might be worth it to establish a carpool and figure out if you can arrange it in such a way that it's profitable to you.
00:40:50.700 | Even if it were partial--let's say that your total cost of expense is $4,000, and you split that with $4,000 per year,
00:40:57.700 | and you split that with somebody else, and they pay you $2,000--it's a win-win. It saves them $2,000.
00:41:03.700 | Well, that converts $2,000 of your expenses that previously you had to earn income, pay taxes, and then do that.
00:41:11.700 | It converts it over, and you save the tax on the $2,000, whatever you would have paid.
00:41:16.700 | So that would be just one example of how these could be put together.
00:41:21.700 | So once you understand the tax formula--and with this, we'll wrap up for the day--once you understand the tax formula,
00:41:26.700 | then it opens up a world of opportunities to you.
00:41:29.700 | Now, I plan to go through and actually talk through some of the exclusions and deductions and credits
00:41:37.700 | and kind of individually explain my way through them best I can.
00:41:42.700 | And I've never heard that done in an audio format. I hope it's not boring, but even if it is, I think it's important enough
00:41:49.700 | that I think I'm still going to risk it, because it's nice to be able to have it in an audio format
00:41:57.700 | where you can think it through over a period of time.
00:41:59.700 | Let's say it takes me five minutes to explain each one.
00:42:01.700 | You don't have to, at a rush, at tax time, go and look for it.
00:42:05.700 | So hopefully this was helpful to you. I trust it is. I appreciate you listening.
00:42:11.700 | I've got an exciting week here tomorrow. It's going to be an interview with John Pagliano.
00:42:17.700 | John has a financial advisory firm called Investable Wealth, LLC, and he also has a podcast called Wealthsteading.
00:42:25.700 | I've already recorded that interview. It's a good one. It's fairly lengthy, but he's a millionaire next door.
00:42:31.700 | He converted himself into a millionaire by about the age of 50, and he did a great job with that.
00:42:35.700 | So we're going to talk with him and see what we can learn from somebody who's already been there.
00:42:39.700 | Thank you for the reviews, those of you who left me reviews.
00:42:42.700 | I got a review from Nervea. It says, "Great information. Four-star review. Great information. A bit long and something rambling.
00:42:48.700 | Joshua tends to repeat himself a lot and ramble a bit. I wish he would take the time."
00:42:51.700 | I already read this one last week. Five-star review from MTBKR.
00:42:55.700 | "Motivating. I love listening to the interviews because I believe in following successful people.
00:42:59.700 | Hearing how others got started and how they're able to maintain their lifestyle is very useful.
00:43:03.700 | When I first saw that one was three hours long, I said, 'What are they going to talk about?'
00:43:07.700 | But it got me hooked, and it turned into a podcast marathon."
00:43:10.700 | Howie Rules says, "Each podcast I listen to, I learn it, and I add them to my plan. Keep them coming."
00:43:15.700 | Thank you very much. Howie Rules says, "Five-star. Excellent content and relaxed delivery.
00:43:19.700 | Joshua does an amazing job at navigating and explaining personal finance so that the average person understands it.
00:43:24.700 | He's well-traveled and open-minded, so you get an education on life from him.
00:43:27.700 | He's kind of an old soul with the right mix of vitality and excitement."
00:43:30.700 | Thank you, Howie. My friends always told me when I was 16, "Joshua, you're 16 going on 73."
00:43:35.700 | And then I got a five-star review here from Patrick.
00:43:39.700 | "Entertaining and educational. Great show that's very much worth your time.
00:43:43.700 | Joshua doesn't try to force a one-size-fits-all approach onto your financial situation.
00:43:47.700 | Everyone has their own priorities, and even he has a unique perspective of his own.
00:43:51.700 | He'd like a more succinct format. Working on it, Patrick.
00:43:53.700 | Today was short, 43 minutes. Hopefully you like that better. See you all tomorrow.
00:43:58.700 | [music]
00:44:11.700 | The holidays start here at Ralph's with a variety of options to celebrate traditions old and new.
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00:44:21.700 | your go-to shrimp cocktail, or your first Cajun risotto,
00:44:25.700 | Ralph's has all the freshest ingredients to embrace your traditions.
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00:44:34.700 | Look for the locked-in low prices tags and enjoy extra savings throughout the store.
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