 Income tax 2022-2023. Income tax formula. Let's do some wealth preservation with tax preparation. Remember the three major tools we have available to us when learning income tax law being the tax formula, the tax forms, the tax software. Obviously these tools are interrelated but I suggest thinking of them separately because each tool lends itself to a different perspective, a different angle on the tax law. Support accounting instruction by clicking the link below giving you a free month membership to all of the content on our website broken out by category further broken out by course. Each course then organized in a logical, reasonable fashion making it much more easy to find what you need than can be done on a YouTube page. We also include added resources such as Excel practice problems, PDF files and more like QuickBooks backup files when applicable. So once again click the link below for a free month membership to our website and all the content on it. Looking at tax law from different angles in general is good because looking at any problem from different angles allows us to understand the full problem better and whenever we're solving a particular problem, choosing the correct angle to look at that problem from might make it a little bit easier, more efficient to solve that problem. So this time we're going to be looking at the income tax formula, which is usually a more of a simplified conceptual way to look at the tax code, which will be easier to visualize. So when you're going through tax problems or tax scenarios in your mind, usually we're going to have a more simplified format in our mind or possibly in an Excel worksheet that we can use to get a gist of what would happen under different scenarios. Then we have the tax forms, which is going to be a more extended type of formula. And that of course is going to be linked to the tax software, which helps us to do the data input, which populates the tax forms. Here is an example form 1040. We're populating some information into this 1040 with LASERT tax software. You don't need tax software to follow along, but if you have access to tax software, it is a great tool to run scenarios with. You can also get access to the form 1040 and related forms and schedules at the IRS website at irs.gov, irs.gov. So if we just look at the 1040 itself, then we could populate the 1040 basically by hand, manually inputting the information into the form 1040. Obviously using tax software can help us to run different scenarios more easily by doing the data input screens. And then that will populate the form 1040. So even tax professionals are not oftentimes going through the form 1040 and reading each line on the 1040, but instead they have a general idea of the structure of the overarching outline of the 1040 and they're putting the data input into the system, jumping then to the 1040 to see if the 1040 is doing what you would expect it to be doing. Now, of course, it is a good idea to go through the 1040 and look at the different areas within the 1040 and read through it. And that's going to be kind of a more complex income tax formula. And then to conceptualize that, obviously we're going to have to simplify that in our minds so we can picture or visualize what we think is going to be happening as we make changes. So the 1040 obviously upfront, up top, we've got just basically informational data, the taxpayer and the address. We'll go into this in more detail later. We got the status information we'll go into in more detail. And then in essence, you have an income statement. It's a very weird income statement. It's a tax income statement that's been influenced by tax law and other incentives and weird stuff. But it's basically an individual income statement. So you've got the income line up top. And then you've got adjustments to income. You got the standard deduction itemized deductions. And the bottom of page one is basically net income or taxable income. And then page two, in essence, calculates the income and then has any other taxes that are applied like like self employment taxes or something like that. And has the credits, which is a whole nother world of confusion. And then we have the payments to get to the to the refund or the amount that is due. Now most tax formula will also give you basically a tax formula format a more summarized way to see this unless sir, it's called the tax summary. So if I jump on over here, now I've got basically an income tax equation. It's trying to show it to me in a simplified way so I can jump to it and see more quickly what is happening. This is the type of thing that will basically visualize in our mind. I also oftentimes put this formula into an Excel worksheet so I can actually manually to some extent recalculate some of the tax return because when you do taxes, unlike when you do like accounting for a business that has a double entry accounting system that at least helps you to check if you've made any errors at least gives you some check. The tax code doesn't give you as much check for individual income taxes. So miskeying is a problem. So if you enter it into like a tax formula and double check it that way, that could be a way to better conceptualize what is going on and it can give you kind of a double check to see that you didn't miskeying a thing into the tax codes. That's my general process oftentimes. So given that let's try to look at this just with regards to the income tax formula, the thing that we're going to visualize in our mind, the thing that we will be seeing when we do actual tax preparation in basically an Excel worksheet. I'll actually build an Excel worksheet and we'll do this together that will kind of mirror the structure of the income tax system itself, the tax forms themselves. But because you could see the links in Excel, it might be a little bit more conceptually easier to see. I know it is for me. So the top line of the tax formula is going to be income. We have an income tax. Notice if you look at the actual form 1040 income is this vast area up top. Now notice that if you were to create your tax formula, most of the time if you were doing this in Excel, as we will see, you would probably make an income line and then put all of the stuff that goes into the income line in other schedules. They started to do that a couple of years ago. They tried to put schedule one, two, and three, which kind of gives more information about like income lines and expense lines. And you would think like if they started from scratch, that's what they would do. They wouldn't have everything on the first page of the form 1040. They'd say income and then all the other types of income might be in a different schedule that feeds into this income line. The reason they didn't do that at the start is because it used to be that you didn't have software to send multiple forms in and they wanted to have simple tax returns to be done on one form, not having other schedules and whatnot. But now other schedules aren't as much of a problem because we file electronically. And so it kind of makes more sense to do that. So now that's why we have in our mind, we're going to say what constitutes income, what kind of things are going to be included in income. Obviously W2 income is going to go in there and dividend income, capital gains and stuff like that. But then it gets a little bit more complex when you start to think about business income, because business income has income and expenses that we'll have to pull in with a schedule C. So you get into some kinds of income that also have kind of expenses tied to them that we'll have to pull in here. Now the income line item, also the general rule for the code is usually anything that you receive as income is basically income unless the code says otherwise. So basically if you find $100 on the ground, unless the code says that it's excluded from income, then you would think it would be income income for taxes is bad. Remember that taxes flips everything on its head. So if you have to include something in income, that's a bad thing because you're probably going to be having to pay taxes on it. What you would like to have happening is you earn income, but it's excludable from income on the tax line because the tax code says so. So basically if you had like a 401k plan or something like that, then that about might be removed from the income line item, but done so on the actual form W2 in box one of the W2. So we'll talk more about that later, but it's actually a topic in and of itself that we'll dive into in terms of what is income, what's included in income, what's not included in income. And then we have adjustments to income. So this used to be called like above the line deductions. You can call it that because they're the higher deductions as opposed to below the line deductions. You can call them deductions or adjustments to income because the reason they call them adjustments or I would think the reason they have it as adjustments is because they're trying to say you can think of it kind of like an income statement that has a contra revenue account, which is like returns and allowances. So then you've got it instead of a deduction, they caught you kind of call it a contra sales kind of item. And the reason is because they want to get down to this adjusted gross income. And this adjusted gross income is actually the number that will be used to calculate phase outs most of the time. So for example, if you've got earned income credits or any kind of credit generally are or certain types of deductions as your income goes up, then you might get less and less access to those credits because they're trying to give those benefits possibly to lower income in some cases and so on. And so they base those phase outs usually on the adjusted gross income, not on the top line income line. So that's why it's kind of an above the line item. That's why you might think of it as an adjustment to income, even though it's basically the same as a deduction. There's not as many items in this adjustments to income up top as there are in the itemized deductions, which is the main area we mostly think of when we think of the different kind of deductions. The major one that's up here above the line is going to be an adjustment for your an IRA type of a deduction is often thought of as above the line. If you think of a 401k, it's a little it's a little bit tricky because an IRA will actually be an adjustment here. A 401k or something will already have been removed from income, but it's reported on the W2. So you won't have included you will not have included it in the income line. Again, it's basically the same thing as a deduction. But basically it was taken out before you put anything into the income line by your employer on the W2, whereas an IRA is an example if they can't do that because your employer's not doing your IRA and you're doing the IRA. Therefore you have this above the line kind of deduction, but it gets to the same bottom point or in general, which would be adjusted gross income, the AGI. So that's a very important number because your phaseouts will be based on that number typically. And then we take the greater of the standard deduction or itemized deduction. So the standard deduction is a deduction basically that everybody gets. It usually goes up each year with inflation. So it's and it's going to be different dependent upon mainly your filing status and some other kind of circumstances as well, meaning are you singled head of household married filing joint. So we'll get into those filing statuses and what the impact on the standard deduction would be. But the most general concept would be well, if we're not trying to disincentivize marriage, you would think whatever the standard deduction is for a single person would be doubled basically if you're married filing joint, because now you've got two people that instead of one filing the one tax return, and that means possibly that income could be doubled. And that's generally how it works. And then head of household is kind of in between. Usually you need a dependent for that. And then you've got the itemized deductions. Now the itemized deductions is usually the place where we think of as most of the deductions like the mortgage interest deduction, the state taxes, you know, property taxes and things like that. Usually the charitable deductions mainly are in the itemized deduction. So a lot of the deductions that come to mind are in the itemized. Now a few years ago, they tried to simplify the code. And one way you can imagine they simplify the code is to say, let's just do away with all these itemized deductions. And let's do away with some of the all the stuff and just give everyone a standard deduction. That would be a way to greatly simplify the code. Obviously that's quite difficult to do. And no matter what you do to the code, there's going to be winners and losers. So what they try to do is increase the standard deduction. That's what they did, which basically means that's a step in kind of making it more simplified because now more people are just going to be taking the standard deduction. Now you would think usually that the itemized deductions are going to be helping out more well off individuals usually because the more well off you are, the more likely you're going to have higher itemized type of deductions. And that's just a general idea. So as people get more income, they're likely to be moving from a standard deduction to itemized deduction. And that usually makes the return more complex. Also just want to note that we're thinking about this as basically an it's an income tax. We have an income statement in essence. We have income minus we've looked at two categories of deductions or adjustments to income and deductions or three categories depending on how you count the greater of the adjustments to income above the line and then the below the line, which includes standard deductions and itemized deductions. Now you might think, is there a general rule with an income tax? If I was to ask somebody to make a tax code from scratch and say, what would make sense if you're going to apply an income tax? Most people would, you'd get to the point where you'd say, well, obviously I can't really tax the gross income, maybe I instead usually have to tax the net income. And this is most clear when you're looking at business income, because if you have two different businesses and you're applying an income tax to them, and one business has very little expenses and the other business has to invest a lot of expenses in order to generate their gross income, then it wouldn't be fair to tax the top line, their income line. It would only, you would think be fair to tax the net income. Otherwise you would be incentivizing businesses that have very little expenses because the one that has a lot of expenses doesn't get the tax benefit. They're getting taxed on their gross income. So in general, you would think an income tax would mean that anything that's a valid deduction would be the things that you had to expend in order to generate the revenue. That would be a natural, valid income tax type of deduction. But with individual income taxes, it's a little bit, we don't really see that oftentimes because most people work as a W2 employee. And as a W2 employee, the concept, the idea is that you don't have to pay for your own expenses in that case because the employer pays for the expenses. So the whole idea of being a W2 employee is that you don't have business expenses because the employer should be taking care of those. So and then of course, we added all these other expenses that have other social kind of rationale for it, meaning the tax code might be manipulated or adjusted by the law because they want to stimulate the economy possibly, or the tax code might change under the law because they want to incentivize one thing or another thing, such as if they want to incentivize more house construction or something, they might do something like allow you to deduct mortgage interest and stuff and stuff like that, which some of those itemized deductions you would think from a natural tax code standpoint would be kind of weird. Like why would you deduct the state taxes for the federal income taxes? You know, it's not really exactly a business expense like why and you would think the state should be separate from the Fed. So that's kind of weird. The mortgage interest thing is a little bit, is quite strange because it's your personal residence. So why would you, if it was an income tax, you didn't have to spend that money in order to generate the revenue directly. So it seems like that's a personal expense. Obviously, they have different rationale, such as they want everybody to have a house or whatever the rationale will be. We can argue whether that rationale be good or bad. It's just not exactly natural, what you would naturally think for like an income tax, charitable deductions. Obviously, again, you can see the rationale, what we're trying to incentivize charitable deductions. But again, it's a deviation from just what you would think would be natural type of deduction for an income tax. And obviously as the tax law expands over time, different kind of whatever's in the current vogue thing that they want to incentivize might make its way into a deduction or a credit on the tax code. If you look at the business taxes for like a schedule C, then you'd see what you would expect from like just a natural income tax without the government trying to manipulate, nudge people or whatever they're trying to do with other types of deductions. Obviously 401k plans and IRA deductions are an attempt for the government to nudge people to save for retirement. That's going to be the idea. They're trying to influence your behavior through the tax code. So a lot of that kind of manipulating of behavior, altering incentives is done through the tax code. Okay, so this is going to be one of the major kind of two. If it's a standard deduction, that'll be a much easier return. If you're a tax preparer, then you might try to think to yourself, where is my focus going to be? Do I mainly want to focus on lower income tax returns who are normally going to be taking the standard deduction, usually tax returns where I make less of a profit margin per return, but I can usually do a lot more returns because they should be a lot easier if I don't have all the itemized deductions and whatnot. Or am I going to focus on higher income tax returns, in which case I'm usually going to have a lot more itemized deductions, adding a lot more complexity to the situation. Because of the more complexity, I'll do less tax returns, but I'll have a higher profit margin, more money per return, and you'll probably have have more opportunity to do income tax planning for the higher income individuals. So those are a couple things that you might want to keep in mind. Obviously, then you can also think about, do I want to do individual tax returns or focus on business tax returns as well, such as Schedule Cs, S corporations, C corporations, LLCs, partnerships, and that kind of thing. And if you go into business tax returns, you might have a specialty in that area by industry and or type of business entity, meaning do you want to specialize in real estate or construction or something like that, something with inventory, and usually those industries often will gravitate first to a particular form of tax, meaning a tax type like a sole proprietorship, partnership LLCs corporation, and so on. All right, so then you've got the taxable income, that's kind of like the net income. And so now you're to the bottom line in essence, where you would think you can now apply the tax calculation on like the bottom line of in essence, the income statement, which is what happens here. But the tax calculation, as we saw briefly, because of a progressive tax system is quite complicated. So as we saw that complication, then means that we're usually going to be reliant on tax software to do this actual calculation. So in practice, all oftentimes recalculate all this information down to the taxable income to double check the data input using an Excel worksheet, but dependent to a large degree on the tax code to apply the actual tax calculation, because of the progressive tax system involved, and it's even more complex than that progressive tax system, multiple tax rates being applied to the tax calculation using tables possibly, because you might have other income subject to other kinds of taxes, such as dividends might be subject to a different tax rate, you might have like passive income kind of situation capital gains might be subject to a different tax rate and so on. So it can get quite complex, even if you get to the taxable income correctly to basically think about what that tax rate will be and we're dependent on the software to some degree. So then we've got the tax before credits and other taxes. So you might think, Hey, this is the bottom line. This is it. There's the calculation of the taxes. But no, for a couple reasons. One is because we on the income tax system, it's a pay as you go as they say type of system. So for the tax year 2022, we cannot wait until we do the tax return by April 15th or April 18th or whatever of 2023 to calculate the tax and then just pay it at that point in time. You might say, Well, they're helping us out. They're helping us out to do that by withholding during the year. Well, no, they're not just helping us out. They want their money sooner, right? You can't do that or else you'll get hit with penalties and interest. You have to pay during 2022 in order to avoid the stick of penalties and interest. So most people do that with withholdings throughout the year, the W2s withholdings, or if you have a sole proprietorship, then you have to pay estimated taxes. So we're going to of course have to compare the tax that we owe to the tax that we already paid. Now, if it was a perfect world, if it was a flat tax, if it was a simple system, if we didn't have millions of deductions and credits to kind of muddy up the waters, then it would be like payroll taxes. The amount that we owe and the amount that we pay would match and we would get no refund. We would get no amount that is due, but the tax code is way too complicated for that. We can't possibly hit it on the nose and therefore we usually shoot for a refund. The other reason we can't stop here, of course, is that there could be other taxes. We might have other taxes such as self-employment tax being one of the big ones that could be included and we could have credits. So credits are different than deductions because credits are going to be below the tax calculation. You'll get a dollar for dollar benefit on the credits versus the deduction where you just get a reduction of the tax. So next line then, tax credit and other taxes. So other taxes, you might be subject to like self-employment tax. Now notice that what we're talking about here is an income tax for the federal taxes. So we're not talking about self-employment tax, you might say. Well, what is this Medicare and Social Security shouldn't be on the income tax? Those are payroll taxes and usually they're not really going to be included if you're doing just W2 income because the Social Security and Medicare was handled by the employers and it's not really part of the income tax kind of thing, even though it is on the W2. But you could run into situations where there's problems such as you have multiple employers and the person paid too much into Social Security and Medicare or Social Security at least because they went over the cap or you might have a situation where they're not an employee but they're sole proprietorship and the government then wants to calculate the Social Security and Medicare but they can't do it through the employer, they can't do it through payroll taxes. So we in essence have to do it on the income tax with other taxes, which is going to be the self-employment tax calculation. So that's when you then have to deal with on an income tax system, the Social Security and Medicare, which are usually kind of payroll taxes, which are the self-employment tax. And then we've got and also note that the credits, when we think about the credits, we've got what we might call the non-refundable and refundable credits. So non-refundable credits would be what we would normally think of as a credit, meaning you're going to get a benefit but you can't go below zero. So in other words, if you don't owe any tax, if your tax liability is zero, like then you're not going to get what we would call a refund, right? Because your tax liability was zero. So the credit will take you down to zero if it's applicable, but it's not going to take you past that. But some of the credits are refundable because they're more of a welfare kind of program. And therefore if they're refundable, they could take you below zero, which could result in a quote refund in quote, even though it's not really a refund, it's kind of a benefit program at that point in time. Also note that credits are similar to deductions in that they're both good. So we like credits, we like deductions as tax payers. But the credit, if you had $1 of credit versus $1 of deduction, the credit would be more valuable because you would get that full dollar back in terms of a tax benefit versus a dollar of a deduction would only reduce the taxable income. And you would only get a benefit that would be dependent upon the tax rate that is being applied to the taxable income. So if you can get a dollar credit versus a dollar deduction, you would generally want the credit. But of course, the credits usually phase out and all that kind of stuff. So it gets way more complicated. Oftentimes. All right, so then we've got the total tax. So we're finally down to the total tax. And that's going to be compared to or subtracted from the tax payments and refundable credits. So if we get down to the actual tax, then we're going to compare that to what we paid in usually with the W two withholdings, but also we might have payments that we made in if we have a sole proprietorship or something like that needing to make estimated payments. And then we have the refundable credits. Notice they had to be separate on the tax return, so that the refundable credits can be those that will extend beyond taking you below zero, resulting in a refund, even if your tax liability because below zero, whereas these credits will not. So that makes the second half or the second page of the 1040 confusing. And that finally gets us to the tax refund or the tax due, which of course is the bottom line. Most people hoping for a refund if they have paid more than the tax liability, but you might end up with a tax due, which could result in penalties and interest. Remember, the whole rationale of getting a refund isn't for the joy of getting a refund and going out, you know, to dinner or something on April 15th or whatever. The benefit, the reason we do it, is to avoid getting hit with a stick from the IRS of penalties and interest. Everything we do, all the planning that we make always in our mind is I want to be in compliance with the law, but pay as little tax as possible. That's always the question in mind. How do I do that? I shoot for a refund because if I get a refund, although I'm losing some time value of money because I could have got the money sooner and either spent it or invested it earning a return on it, I'm willing to do that to avoid underpaying in which case I get hit with the stick of penalties and interest. That's the point.