How to Read Your Tax Return

I know, I know. You must be thinking, “Taxes! Two weeks in a row?” 

Yes, two weeks in a row. You should know how to read your tax return. I understand taxes are boring for most people, and trying to understand the tax code is a little like trying to do your own open-heart surgery at times, but the reason taxes are important is because they touch most aspects of your financial life. 

Do you want to pay more in taxes than you are legally obligated?

If you are like everybody else, the answer is no.

The problem is plenty of people pay more in taxes than they are legally obligated. It’s a result of not understanding the tax code, not reviewing their tax return, and not proactively planning for the following year. 

You may have already finished your tax return or are putting it off as long as possible. Either way, let’s help you make sense of your tax return when it is complete. 

I am going to help you understand each line and the planning ideas that you can consider to improve your tax situation. 

As with all my articles, this is not tax advice. It’s not planning advice. It’s not legal advice. This is for educational and informational purposes only. You should consult your own accountant, financial planner, or attorney who is familiar with your own situation. 

How to Read Your Tax Return – Understanding Each Line

Form 1040 is your individual income tax return. There are many types of tax returns, but we are only looking at Form 1040. If you look at your own tax return, it should look like the one below, but with everything completed.

Form 1040 - How to Read Your Tax Return Page 1
Form 1040 - How to Read Your Tax Return Page 2

The first part of Form 1040 is simply your name, Social Security number, and other identifying information. It also includes your filing status. One of the more common questions for married people is “Should we file married filing jointly or married filing separately?” 

For most married couples, married filing jointly is going to result in lower taxes. It’s rare for married filing separately to make the most sense, though there are a few situations where it sometimes pans out:

  • Financial protection – if you don’t want to sign off on your partner’s reporting, often because you worry they may be misreporting information, you could file separately. It likely won’t mean less in taxes, but it does offer you better protection. This often comes up during divorces. 
  • Student loans – if one of you is on an income-based repayment plan, sometimes filing separately can mean lower student loan payments that more than offset the increase in taxes by filing separately. Each situation is unique, which means you’ll want an accountant to do mock tax projections if you filed separately and jointly to determine the difference in tax and then compare it to your student loan payment amount in both scenarios. 
  • High deductions and significant difference in Income – if there is a significant gap in pay and/or one person has high deductions, such as medical expenses, married filing separately may be worthwhile to consider. 

The married filing separately decision is also complicated by whether you live in a Community Property state or a Common Law state because certain rules dictate how to report income and deductions. 

Suffice it to say, you’ll want to consult an accountant or be very knowledgeable with tax laws before deciding which way to file. 

Before line 1, you also have dependents. 

Dependency tests are complicated. One test is that you need to provide more than half of their support for the year; however, claiming a dependent has multiple tests. For example, to claim a qualifying child, they must be under age 19 at the end of the year or under 24 at the end of the year and a full-time student for at least five months. They also need to meet the relationship, residency, and joint support test in addition to the age and support test named above. You can use the IRS tool to determine if you can claim someone as a dependent.

You can also read more about dependents here and a simpler article here

Please note that even if you claim a dependent, sometimes the dependent is required to file their own tax return. 

Now, let’s look at the bottom half of the first page of your Form 1040. Line 1 is your wages from work reported on your W-2. 

Planning Tip:

If you want to reduce the amount reported on Line 1, you can make Traditional 401(k) contributions or HSA contributions if you are covered by a high-deductible health plan. For example, if you earned $70,000 in gross income, but contributed $10,000 to a Traditional 401(k) plan, the amount reported on your W-2 that will show up on Line 1 is $60,000. In other words, you are not being taxed on the $10,000 you contributed to the Traditional 401(k) plan. If you could contribute $2,000 to an HSA, your income would drop to $58,000. In both scenarios, you are making pre-tax contributions, which reduces how much of your income is taxed. 

Line 2 is your interest – both tax-exempt and taxable interest. If you held $10,000 in your bank account last year and earned 0.50%, your bank would issue a 1099-INT that reports about $50 of interest. This is reported on Line 2b. This interest is taxable to you at your marginal tax bracket. Tax-exempt interest is commonly earned by investing in municipal bonds. The interest paid from municipal bonds is typically not taxed at the federal level. 

Line 3 are your dividends – both qualified and ordinary – from brokerage assets. A dividend is a distribution from a corporation to shareholders. Qualified dividends receive preferential tax treatment while ordinary dividends are taxed as ordinary income. Qualified dividends are taxed at capital gains rates, which can be 0%, 15%, or 20%, depending on your income. Ordinary dividends normally come from taxable bonds, REITs, and stocks held less than two months. 

Planning Tip

Look at your 1099 form from your brokerage company to determine which investments are paying qualified dividends and ordinary dividends. Your ordinary dividends on Line 1a are your total dividends, including non-qualified and qualified dividends. If Line 1b equals Line 1a of your 1099, this means 100% of your dividends were qualified dividends. If Line 1a had $500 of ordinary dividends and Line 1b had $400 of qualified dividends, this means $100 was non-qualified dividends, which will be taxed as ordinary income.

Short-term capital gains are also included in Line 1a, which are investments bought and sold within a year. This could alter the ratio of qualified vs. non-qualified. 

You may want to sell some of your investments paying ordinary dividends in your brokerage account and instead buy them in a tax-deferred account, such as an IRA, because you will not be taxed on them each year. If you have significant gains in your brokerage account, this may not make sense. 

Form 1099-DIV

Line 4 are your IRA distributions, which is money distributed from an IRA, a type of retirement account. Line 4a is the total distribution amount, including rollovers of 401(k) plans to IRAs. Line 4b is the taxable amount. For example, if you rollover $50,000 from a 401(k) to an IRA and take no distribution from an IRA, $50,000 would appear on Line 4a and $0 would be on Line 4b. 

Planning Tip:

If you are making $6,000 backdoor Roth contributions each year, Line 4a would show as $6,000 and Line 4b would be $0 if you made the contribution and immediately converted it to a Roth IRA because there would have been no growth. If you did not immediately convert the $6,000 contribution and it grew to $6,500 when you converted it, $6,500 would be on Line 4a and $500 would be on Line 4b. The $500 is the amount taxable to you.

It’s usually best to immediately convert the contribution. Backdoor Roth contributions are a good way to grow a tax-free bucket of money when you earn too much income to qualify to make a Roth contribution directly. 

Line 5 are distributions from pensions and annuities. Most people are not receiving pensions or annuity distributions, but if you did, they would show up here. 

Planning Tip:

Annuities are often sold to people as a tax-deferral tool. Please be wary if someone is trying to sell you an annuity. They often come with high fees, and although growth is tax-deferred, you’ll pay ordinary income tax on the earnings when withdrawn, whereas if you invested money in a brokerage account, it is typically taxed at more preferential capital gains rates.

If you only withdraw a little money from the annuity in the future, you will pay ordinary income on the earnings until you have fully taken out all the earnings. Only after that point do you receive the amount you put into it without paying taxes. It’s often not as tax favorable as people make it out to be! 

Line 6a is Social Security benefits. Fun fact: only up to 85% of your Social Security benefits are taxable. Depending on your income, 0% or only 50% of your Social Security benefits could be taxable. For most of my audience, you don’t receive Social Security benefits, but you could share this fun fact with your parent or grandparent. 

Line 7 is your capital gains or losses. Long-term capital gains, which are investments bought and then sold after a year, are taxed at the more preferential capital gains tax rates (0%, 15%, or 20%). Short-term capital gains, which are investments bought and sold within a year, are taxed as ordinary income. If you realize losses during a tax year, you can deduct your losses against capital gains and if you have losses left over, you can use $3,000 to offset your ordinary income. Any unused amounts are then carried forward to future years to offset capital gains and then up to $3,000 of ordinary income each year. 

Planning Tip:

In a year where markets go down, it’s normally wise to take advantage of losses by tax-loss harvesting in your brokerage account as they occur instead of waiting until the end of the year. For example, in March of 2020, most stock investments went down around 30%. If you had invested $10,000 in a brokerage account and the investment went down 30%, it would have been worth about $7,000.

At that time, you could have sold it, bought another similar, but not identical investment around the same time. This way you booked the $3,000 loss and still participated in the upside of the market as it recovered. There are very specific rules that need to be followed when tax-loss harvesting in order to avoid wash sale rules. Before taking action, you should become knowledgeable about the rules. 

Line 8 is other income from Schedule 1, which includes taxable refunds, alimony, business income, rental real estate, royalties, partnerships, farm income, and unemployment compensation. There are other types of income, but it’s like a catch-all of additional income. 

Line 9 is your total income. 

Line 10 is adjustments to your income, such as from Schedule 1, which includes things like educator expenses, health savings account deductions, deductible part of self-employment tax, self-employed SEP contribution, self-employed health insurance deductions, alimony paid, IRA deductions, student loan interest deduction, tuition and fees deductions, and others. For 2020, it also includes up to $300 in cash charitable contributions if you take the standard deduction. They are allowing this again in 2021, but married filing jointly can deduct up to $600. It remains at $300 for single filers. 

Line 10c will list total adjustments to income. 

Planning Tip:

If you have self-employment income, you have many deductions available to you. You should work with an accountant or spend time familiarizing yourself with what’s available to ensure you are not paying more in taxes than you are legally obligated. You should not do this at tax time. You should be doing it throughout the year. 

Line 11 is your adjusted gross income (AGI). It’s your gross income minus the adjustments mentioned above. Your AGI is important because it helps determine your total tax liability and eligibility for deductions and credits, which can reduce your tax liability. 

If you hear people talk about “above the line” or “below the line” deductions, Line 11 is “the line.” Above the line deductions are normally more valuable because they reduce your AGI, which reduces your total tax. Below the lines deductions are also valuable, but they tend to be less valuable because they are itemized deductions and not everybody is able to itemize their deductions. I’ll talk about this more below. 

Line 12 is the standard deduction or itemized deductions. You either take the standard deduction or itemized deduction, but not both. The way it works is if your itemized deductions add up to more than the standard deduction, you itemize your deductions. If your itemized deductions add up to less than the standard deduction, you do not itemize and take the standard deduction. Basically, you take whichever number is larger. 

Itemized deductions are put on Schedule A. 

Schedule A - Itemized Deductions

Itemized deductions include:

  • State and local taxes (up to $10,000)
    • State and local income taxes or general sales taxes
    • State and local real estate taxes
    • State and local personal property taxes
  • Home mortgage interest and points
  • Gifts to charity 
  • Casualty and theft losses from a Federally declared disaster

Let’s look at an example of whether you would itemize or take the standard deduction. If you paid $5,000 in income taxes, $5,000 in mortgage interest, and contributed $1,000 to charity in 2020, you would have $11,000 of itemized deductions. 

The standard deduction for single filers is $12,400, which means your itemized deductions add up to less than the standard deduction. This means you would take the standard deduction of $12,400 on Line 12. 

If you contributed $5,000 to charity in the previous example, now your itemized deductions equal $15,000, which is larger than the standard deduction. Line 12 would show $15,000. 

Married filing jointly has a $24,800 standard deduction for 2020 and it will be $25,100 for 2021. The Tax Cuts and Jobs Act of 2017 raised the standard deduction, which made it more difficult to itemize deductions. Most people will take the standard deduction because the state and local taxes are capped at $10,000, meaning even if you paid $20,000 in state and local taxes, you can only deduct $10,000. This means your mortgage interest or gifts to charity need to be very large to have your itemized deductions be above the standard deduction. 

Line 13 is the qualified business income (QBI) deduction. It allows self-employed people to deduct up to 20% of their qualified business income. There are special rules about which types of businesses qualify and eligibility phaseouts above certain income limits. 

Line 14 is line 12, standard deduction or itemized deductions, and line 13, QBI deduction, added together. 

Line 15 is your taxable income. Your taxable income determines your tax bracket and your total tax liability.

Something that confuses some people is what it means to “be in a tax bracket.” For example, if you are in the 24% tax bracket, this means each additional dollar you earn is being taxed at 24% – not every dollar you earned previously. The other income was taxed at lower rates. 

For instance, single individuals who had taxable income of $86,000 in 2020 had the first $9,875 of income taxed at 10%, the next $30,250 at 12%, the next $45,400 at 22% and $475 at 24%. 

We’ll skip the next few lines because they are calculations and credits. 

Line 24 is your total tax. This is not necessarily how much you paid in taxes, but the total tax liability. 

Line 25 lists how much you had withheld from your job and other sources of income. 

The next few lines say whether you made estimated tax payments or received credits, which will help factor into the amount you owe or the amount of your refund.  

Line 32 is the total of all your payments and refundable credits. 

Line 33 is how much you paid the IRS. 

Line 34 is if you paid more to the IRS than you owed, meaning line 33 is larger than Line 24. This is commonly referred to as a refund, which shows up on line 35 if you want it paid to you instead of applied to your next year’s estimated tax. 

Planning Tip:

A refund is not necessarily a good thing. It’s an interest-free loan to the government. It’s money that was always yours, but you decided to have the government hold it for you. I know some people like receiving a refund, and I can admit psychologically it’s nice to get money back, but economically, it’s not a benefit. It’s your money the government is merely returning to you. Ideally, it would be best to get a small refund or owe a small amount. 

Line 37 is the amount you owe if line 33, the total amount you paid in taxes, was smaller than line 24, the total tax liability. 

Planning Tip:

If you owe more than $1,000, you may be subject to underpayment penalties. To avoid underpayment penalties, you can pay in 100% of the prior year tax, line 24, or 90% of the current year tax through withholdings or estimated tax payments. The 100% prior year tax rule moves to 110% for people with adjusted gross incomes above $150,000 in 2020. 

Summary – Final Thoughts

If you made it this far, treat yourself to something special. Taxes can make anybody’s mind exhausted, including accountants. 

As you can see, there are many rules when it comes to taxes. A quick search on the internet won’t always turn up the correct result and sometimes it is flat out wrong information. Although the IRS website is dense, it is comprehensive. I recommend reading the IRS website whenever possible to find your answer. It may take time, but it’s usually there. 

I encourage you to review your tax return, even if you use a software to prepare it guiding you through question-by-question or if you have an accountant prepare it. Understanding each line on Form 1040 will better prepare you to plan throughout the year. 

This planning is what allows other individuals to pay all the tax legally required, but not a penny more. 

After all, who wants to pay more in taxes than required? 

Good luck with your taxes! 

Disclaimer: This article is for general information and educational purposes only and should not be considered investment, financial, legal, or tax advice. It is not a recommendation for purchase or sale of any security or investment advisory services. Please consult your own legal, financial, and other professionals to determine what may be appropriate for you. Opinions expressed are as of the date of publication, and such opinions are subject to change. Click for Full Disclaimer