“Remember, a dollar saved is a dollar you do not need to earn” – Deb Fox

One of my goals is to make the seemingly complex, simple.  With that in mind, I offer you an IRS Federal Tax primer.

To plan, financially, it helps to understand that not all numbers are created equal. Some numbers provide more benefit than others.

My hope is that this primer will serve as a good tool to refer back to when I write about other tax topics.

The Visual:

– Income
– Above the Line Deductions
= Adjusted Gross Income
– Standard Deduction or Itemized Deductions
– Exemptions
= Taxable Income
– Tax Credits
– Tax Paid
= Tax Owed or Refunded

The Narrative:

Income includes all income except income that is exempt by law

Deductions reduce your tax liability by reducing the amount of income that is taxable

Income minus Above the Line deductions equals Adjusted Gross Income (AGI)

• Above the Line deductions include, in part, monies paid for:

1. Health Savings Account
2. IRA Deduction
3. Qualified Student Loan Interest
4. Self-employed health insurance or qualified pension plans

Adjusted Gross Income minus either the Standard Deduction or Itemized Deductions

• Use the highest number
• The 2012 Federal Standard Deduction for Single of Married Filing Separate was $5950; $11,900 for Married Filing Joint or Qualified Widower; $8,700 for Head of Household

Then subtract $3,800 for each 2012 qualified Exemption = Taxable Income

• Exemptions include you, your spouse, & qualified dependents

Taxable Income minus Allowable Credits

• Credits are either Refundable or Non-Refundable
• Refundable means you can reduce your tax liability below zero – IRS pays you
• Non-Refundable means you can reduce your tax liability to zero

Refundable Credits Include:

• Earned Income credit
• Child Tax credit
• The American Opportunity Tax credit

Non-Refundable Credits include:

• Adoption credit
• Retirement Savings Contributions Credit (Saver’s Credit)
• Lifetime Learning credit

Takeaways:

• Above the Line deductions are more valuable than Below the Line deductions because they are available to all taxpayers and are not subject to income limitation phase-outs
• Deductions reduce the amount of income subject to tax
• Tax credits reduce the amount of tax you pay
• Tax planning can help you reduce your tax liability and keep more of your money
• Remember, a dollar saved is a dollar you do not need to earn.

Keep marching toward Financial Freedom. Happy Planning!