 Income tax 2021-2022, income tax formula. Get ready to get refunds to the max, dive it into income tax 2021-2022. We're gonna start looking at the tax formula in OneNote. If you have access to OneNote, you could follow along. If not, that's okay too. Later on, we're gonna be looking at the formula with the use of Excel, typically in practice. I'll use something like this so that I can double check what has been input into the system, into the tax software, with an outside, possibly more transparent worksheet in Excel. So we'll take a look at that in future presentations. You also might wanna have a Form 1040, which you could find on the IRS website, irs.gov. So you can compare the formula to the 1040. Here's our 1040 in our tax software with our mock client, that being Adam Smith living in Beverly Hills 90210. And you can kind of compare the information down below, and you can see you have basically an extended format of the tax formula. Tax software, we're also often have a tax summary kind of page, which will give you the information in more of a formula basis as well. We'll take a look at that more in a future presentation. So let's go back on over to OneNote. Note, and the first thing you wanna think about and understand is the income tax is a tax on income. That means the first part of the tax formula is gonna be some kind of income statement, a standard income statement you would think of as income minus expenses. That would mean that any natural deduction that you would expect would be deductible would be something that you had to use or expend in order to generate income. So a natural kind of way that you would think about an income tax is that you would say, I've got my income is gonna be on the top line item. And then what kind of deductions would naturally be appropriate for an income tax? Normally you would think of the type of deductions that you needed to expend in order to generate revenue would be the type of expenses that would be natural to an income tax so that the income tax is not being given on the gross income, the top line, but actually on the net income, the income that you had after having to expend the expenses in order to generate income. Obviously the tax code's gonna deviate from that a lot because the tax code is not just there for revenue generation, it's also basically used to influence us in some ways. So when you start to think about the things that are deductible, you're gonna start to say, hey, wait a sec, that's not like something that is used in order to generate income. It's got some other purpose, aim or goal, which is the reason the legislation has been put into place, which makes the income statement in the income tax a little confusing, not a standard kind of income statement, but that's the first starting point you wanna think about. We're doing an income tax. We're gonna get taxed on basically the bottom line of the taxable income statement that we'll start off with income, which we can think about as gross income. Now, we're gonna dive into more detail of each of these line items in the formula. When we look at the top line, which we would typically think of as gross income in an income statement, that's even gonna be a bit more confusing because it's gonna include things which we could think of as gross income like W2 wages, but it will also include things that are from our sole proprietorship that could be reported like on a Schedule C and the Schedule C will have an income statement for the business, which we would imagine more of a common income statement with the gross income minus all the deductions, which in that case are expenses that are used in order to generate the revenue. The net income is gonna pull into the first page of the 1040 and be in this first income line item. So this formula again is a simplified formula that we can kind of hold in our mind. We're gonna have to expand on it to think about what kinds of things we're gonna fit into these particular line items and how much detail we gotta think about in order to think about different changes that are gonna happen, such as what if someone has a Schedule C business and so on and so forth and deductions and income related to it. So then we're gonna have the deduction or subtraction of, and you can think about these as deductions. There's typically two, you wanna think in your mind, two major categories of deductions for the individual income tax return. We are in essence mirroring here the Form 1040. We have what we could call, they're sometimes called above the line deductions and sometimes they're gonna, they could be called a Schedule I deduction now because there's been changes and they're on a different schedule at this point in time and they could be called adjustments to income. So these are kind of the above the line or adjustments to income as opposed to the standard deduction or the itemized deductions. That's gonna give you the adjusted gross income, the AGI. Now this above the line deductions, there's not as many of them. So we'll be able to kind of, we'll go through those, we'll expand on what those deductions are, but those, if you can get those deductions, those have a benefit over the itemized deductions which are possibly the more common deductions that usually come to mind when we're thinking about deductions because these adjustments to income or above the line deductions or Schedule I deductions are not subject to the same kind of either or requirement that we will see in the itemized deductions. In other words, I don't have to clear some kind of hurdle like the standard deduction in order to take them or in other words, I can take the standard deduction and still be able to take the adjustments to income in general. They're not linked to whether or not I take a standard deduction or whether I am itemizing. This subtotal is just gonna be a subtotal on the way down to the bottom of the income statement similar to like a multiple step income statement to get down to a normal income statement terms and down to net income, in this case, to taxable income, but this number is gonna be really important, the adjusted gross income or AGI. The reason it's really important is because a lot of times when you're thinking about credits or when you're thinking about deductions, they have a phase out characteristic. In other words, the tax code is often gonna say if your income goes above a certain level, we're gonna start to phase out the benefits that you get from certain deductions and credits and they're typically not gonna be basing it on the top line, the income, they're at least gonna start out basing it on the AGI. So when we say there's an income limitation, usually more technically, it would be an adjusted gross income based limitation not on the top line. They could be pretty closely related depending on how many adjustments to income there might have. So it's a good key number to keep in mind and then we're gonna be subtracting either the standard deduction or the itemized deduction. Here's where the confusion mostly comes in with people because the standard deduction is a deduction that will be standardized and it'll be based on, in essence, your filing status and a couple other conditions that we'll talk about later. So we'll get into the dollar amounts of the standard deduction, but the general idea is you're gonna have one standard deduction or one set of standard deductions based on your conditions and that'll be it. Or if you have itemized deductions that are over a certain amount, you can take the itemized deductions. So the itemized deductions include those types of deductions that often come to mind when we think about deductions like the charitable deduction, there's an above the line component. So it gets a little bit more tricky, but most of the time, most of the charitable deductions are on the itemized deductions when you think about deductions related to interest and taxes or mortgage taxes, I'm sorry, mortgage interest and property taxes, for example, those are gonna be the itemized deductions. And so when you're thinking about, what's gonna be the impact on your taxes, you've gotta think about the interplay between these two items. Now note, there's often an argument within the tax law saying, I mean, should we simplify the tax code by lessening the amount of deductions, possibly giving a greater standard deduction versus having the itemized deductions. So when they try to simplify the law, they're often saying, okay, what we're gonna do is try to increase the standard deduction so that everybody just has a standard deduction and we're not gonna get into all this itemized deduction business. You'll note that the itemized deductions include a lot of items that, once again, they're not those kind of things that you would think would be natural to an income tax because you would think the things that would be deductible would be those expenses that you need to expend in order to generate revenue. And oftentimes when we look at the deductions that here, such as a personal residence, mortgage interest deduction and the property taxes and whatnot, those are on personal things. So you would think there's some other driving factor or incentive as to why they became deductible other than what would be natural to an income tax. So oftentimes you'll hear arguments on the income tax code saying, well, we should simplify the tax code versus we should increase the itemized deductions having them give them more influence so that we can do things with the tax code and influence people's behavior through the tax code. Those are often gonna be two angles that people think about with tax policy. Do we wanna use the tax code to influence people? Well, that's usually gonna mean that it's gonna be a more complex tax code and that would mean people would probably be favoring more power to the itemized deductions so that they can use those to drive people to do this, that or the other thing based on tax influences. If you're trying to simplify the tax code, then you're probably saying, well, now I wanna lessen the role of the itemized deductions and just have a standard deduction. Also, the itemized deductions probably, of course, favor more well-off individuals because you're more likely to be itemizing if you're more well-off. Generally, you're gonna have more deductions that are gonna be over the standard. So the general rule then would be you're gonna take the standard deduction if it's greater than the itemized deduction. You would only be taking the itemized deductions if they were greater than the standard deduction because you want the maximum benefit for taxes. Benefit for taxes mean that the expenses, which are, in essence, the deductions, are good. Everything's flipped on its head for taxes. So, and that's a key component. Remember, when you're on your business side of things, if you were trying to get a loan, for example, for your business or something like that and you're going to the bank, you're trying to look good. You're in your best suit. You've got your income statement. You're trying to say, this is how much I'm making and you're trying to say, I make enough money to pay back the loan. Give me a loan, please. When you're talking about taxes, everything is flipped on its head. You're trying to look bad. You can imagine visiting the tax person with holes in your jeans and so forth. You're not actually gonna do that, but that would be more of the, right? I don't have any money, right? The expenses are good. The income is bad for taxes because it's an income tax. So that means what we wanna do is take the biggest amount of deductions we can, which would basically be kind of like expenses if you're thinking about a normal type of income statement. So we would only take the itemized deductions if they're greater than the standard deduction. That means that when you're thinking about itemized deductions, you gotta think about, is it worthwhile for me to collect a bunch of the itemized deductions, things like medical expenses and so forth can get quite tedious to be collecting the data on if I'm not gonna be able to get a benefit from them. So we'll break down some of those itemized expenses when we get into that section of the course. Then the next line is gonna be the taxable income. So you kinda think about this as the bottom line of the income statement portion of the tax formula. We're not done yet because we have to calculate the taxes and then we also have the complexities of the credits which are different than the deductions and then we also have the fact that we already made payments on it. So we're really only halfway to the end of the actual calculation here. But this is the part that you kinda are verifying oftentimes when you're filling out the 1040 to see what your taxable income will be. This would be kind of equivalent to the net income if you thought about just a normal income statement, basically income, gross income minus expenses. We've got the income up top minus the adjustments to income which are kind of like above the line deductions to get to that AGI. Then you take either the standard deduction which would typically be easier and normally applies to most taxpayers unless your income is over a certain threshold. Also remember that you might say, well, what's gonna be the factor that basically triggers people to itemize? It's usually something like a home. When they purchase a home, that's one of the biggest deductions because you're gonna be financing a lot of it. And oftentimes the mortgage interest is going to be deductible as well as the property taxes and that's huge deduction that pushes a lot of people over to itemizing. But be careful when you're purchasing a home if they're arguing that you should purchase the home just to get the deductions of the mortgage interest, you gotta be careful on that because the benefit that you're getting isn't really the full deduction of the itemized deduction because you would have got the standard deduction anyways. The real benefit you're getting is the difference between how much standard deduction you would have gotten and how much more benefit you got on the itemized deduction. So once again, for a lot of people it might not be as big a difference as you would think for more wealthy people that might have two houses or something like that and have a larger house and therefore larger financing then it's more likely again to be a bigger significant thing to be itemizing and so on. So in any case, that's gonna be the taxable income. So then we're gonna apply the tax rates you can think about it or in essence the tax table. This is where we're gonna actually apply the calculation of the tax. This is something that we as tax preparers aren't usually doing by hand. We looked at this in the past because we would have to apply the progressive tax system meaning the different rate tables and so on which and if you were to do this with the tables with the actual tables and the instructions for the 1040 you would look up the tables. That's how the software will typically calculate it. And so again, we really rely on the software for this. So in other words, normally we can double check this number up top possibly with an Excel worksheet as we will do. We'll double check these numbers then we'll rely oftentimes on the tax software to do the actual calculation because it's a progressive tax. It's complicated to figure out that rate because you gotta look it up in a table number one and number two is not just a table because you might have more detail than that. You might have to break out the capital gains rates which could be different as well as the dividends rates could be different. So once you've got the tax rate that'll give you the tax before credits and other taxes. So you would think this would be the bottom line of what you owe but no, you also have the credits that are gonna take place. The confusing component about the credits is they kind of combine the credits together with the payments in the tax formula because the credits are equivalent in value to basically something that you paid in to the system. So you gotta be careful when you're thinking about a deduction versus a credit. When you're thinking about a deduction if you're talking about $1 of a deduction or $1 of a credit, the credit will be worth more than the deduction. So in other words, if you had a deduction you gotta think, do I even get the deduction? Because if it's an itemized deduction it's not gonna help me if I'm standardizing. So first of all, am I gonna get the deduction? If it's gonna give you a benefit on the deduction side of things say it's an adjustment from adjustment it's an adjusted gross income deduction or an adjustment to income deduction then you're only gonna get a benefit based on basically the rate that it's gonna be applied to that dollar of the deduction. So you're only gonna get a portion of the benefit of that deduction whereas if it's a credit you're gonna get that full dollar worth of a credit. So a dollar for dollar deduction versus a credit the credit is gonna be worth more than the deduction. That's gonna be the general rule that you wanna keep in mind. So then we're gonna say subtract or add the tax credit and other taxes. So the credits are gonna be things once we're down here we're now looking at the tax this is basically what our liability would be if we had not already paid into the system which we have because the IRS wants to get paid as we go for most people they get paid by your employer taking money out of your W-2 and paying it to the IRS on your behalf. But then we also have the credits that are gonna subtract we're gonna reduce the liability what liability would be for the taxes minus the credit so that's good cause that would make your liability go down but we could also have other taxes that could be involved down here that we're gonna apply that are not the income taxes one of the biggest examples often being self-employment tax. So for example if you work and you have a schedule C business then if you're a W-2 employee you have to pay Social Security and Medicare and the income tax through payroll taxes if you're a sole proprietorship then you're not paying the payroll taxes for your income that you're earning the IRS wants that money so they're gonna include it in self-employment taxes one of the big taxes for many people that people often it hits people unaware of how that's gonna happen because they're so used to being an employee when they move to self-employed they're calculating just on the federal income tax and forgetting about the Social Security and Medicare which in essence of the payroll taxes that are now being applied to them as a sole proprietorship in the form of self-employment taxes. So those are gonna be added that could be added down here depending on the type of business if you're a W-2 employee then you've already paid those taxes because the employer took them out of your wages because they were forced to by the government and so they took them out and you paid them already typically so that's gonna give us then what we'll call the total tax here so we had the tax before we had the tax before credits and other taxes and then we applied out the credits and the other taxes so now we're saying the total tax which would be your liability if you had not already paid in to the system but you have paid into the system because that's what the government wants, right? They want you to be paying into the system as the year goes so if we're talking about tax year 2021 the government wants to be paid in 2021 even though you don't file the tax return until April 15th of 2022 or somewhere thereabouts possibly April 18th of 2022 so they want the money during the timeframe now if the way the tax system was kind of designed it would work something like this in a perfect world what would happen is that you earn revenue and you pay the government their share of the revenue as you earn it throughout 2021 when you file the tax return by April 18th or 15th or whatever of the next year 2022 it should just be an information return in a perfect world in other words you would have the total tax liability that you recalculated and then you would tell the government and I already paid it throughout the year possibly through withholdings from my W-2 wages and therefore you would have no refund and no tax due that's how it's kind of designed to do however that's impossible to do due to the complexity of the tax code in other words it's impossible for us to pay the exact amount of tax that we owe because we have a progressive tax system with multiple tiers because we have multiple people that could be in combined on one return because we got credits that are gonna distort the whole thing as well so it's way too complicated for us to ever get the exact tax calculated so that means that what we try to do is shoot for the refund that's why you have a refund and you can see this in the payroll taxes if you've ever dealt with payroll taxes it uses more of a flat tax and you file the 941s quarterly and normally if you do things properly because it's a more simple tax it's using the same system on a quarterly basis but when you actually file the tax return you're not paying any more tax at that point in time you're just saying hey look this is how much tax I owe based on the calculation I already paid you it when I process the payroll there's no tax, there's no refund at that point in time that's kind of how the income tax was designed to be but it's way too complex to do that because we don't have a flat tax and because the income's confusing because the deductions are get out of control and the credits are a mess and so on so what we do then is we try to say I'm gonna shoot to overpay the taxes so when you look at your tables for the W-2 withholding tables and so on they're designed to overshoot the taxes so if you calculate it properly based on the directions for the filling out your W-4 in order for the withholdings to be taken out of your W-2 they're designed to overshoot so that you pay too much and that's what you're getting in terms of the refund in normal cases so now you got the tax payments which hopefully you paid a little too much in that case to get a refund why do they try to overshoot it instead of undershoot it is it so that you can get a nice surprise of a refund that's not that's you know that might be part of it but really what you're trying to do on your side of things is you're trying to avoid paying penalties and interest how does the IRS kind of enforce this whole system they have a stick they got the stick that they hit people with it's called penalties and interest so if you underpay the tax they're gonna hit you with the stick of penalties and interest we're trying we don't want it I don't like getting hit with the stick so what you're trying to do is overpay a little bit so that you can avoid the penalties and interest because you can't exactly hit exactly what the amount of tax you're gonna owe is so that means that you've got the tax payments down here and then the refundable credits we'll talk more about refundable credits they become more and more significant those are things like the child tax credit which has an advanced portion to it now and you've got the earned income credit which are the two big refundable credits and possibly the recovery rebate credit tied to the economic stimulus payments so those are also gonna be down here refundable means that we could go below the tax we could not only not owe any tax and not just get a refund back because we overpaid the tax but actually get money so in that case if you were using the refundable portion of a refundable credit you would be getting money it's not like you would be paying tax in that case you would be receiving money through the tax code while filing your tax return and it wouldn't really be a refund in that case even though it's still kinda called a refund it would be a benefit kind of program so that's why they're down here in the refundable credits section so we'll talk more about those later and then finally we get to the tax refund or the tax due at the bottom line so this is basically mirroring the actual 1040 every line item on here we can then supplement with another schedule that might help us to give us more detail so for example the income line item might be supplemented with a schedule C a schedule E that helps break down more of that information the adjustments might be on a schedule one to tell us what actual those adjustments are the itemized deductions is gonna be on a schedule A that breaks down the actual itemized deductions so you can think about it if you were thinking about an Excel worksheet format you'd say okay this is the first sheet which is the summary sheet summary formula and then I'm gonna break down each of these line items with a separate sheet that feeds into that first line item when you're envisioning it in your mind then if someone asks you a question and you're saying okay you got a schedule C thing that's gonna ultimately feed into the first line item of the income statement and we'll have an ultimate impact on taxable income of this and so on that's how you kinda wanna visualize it oh you have something that's an adjustment to income which would fall in here which you would have a deduction to the adjusted gross income which could have an impact on your phase outs and so on for other credits and whatnot oh you have something that's an itemized deduction that would be kinda here that would be going on your schedule A would flow into this portion on the first page of your formula that's how you wanna start to visualize in your mind what's gonna happen and then you wanna solidify that by doing practice problems with the use of say Excel worksheets and of course with the use of software.