If you're serious about financial planning, you should understand taxes! The simplest way is to start with your own return and go line-by-line to make sure you understand each and every calculation and input.

Tax Day Challenge: Understand Your Tax Return Line by Line

If you're serious about financial planning, you should understand taxes! The simplest way is to start with your own return and go line-by-line to make sure you understand each and every calculation and input.

It’s tax day!  During my time working at a public accounting firm, this was a day of great celebration. The first half of the day was spent tying up loose ends and the second half was the end-of-season party. Of course, we did file tax extensions for many clients that we’d be working on all summer, but it marked the end of the mandatory long hours and a little more flexibility in schedules.

If you’ve been working last minute on your tax returns, I’m sure you are just as excited about tax day!

My challenge for you today is this: whether you prepare your tax return yourself or hire someone to prepare it for you, you should understand each and every line item and how to calculate your entire tax return by hand.

One of the greatest opportunities you have to improve your personal finances in both the short and long-term is to implement tax planning that reduces your overall tax burden, allowing you to keep more of your own money in your pocket. This is especially true if you have a high income.

Remember, you don’t have to know the entire tax code. You only need to be familiar with the tax laws that relate to your own specific situation. We’ll cover the basics here, but be sure to research any additional situations that you have to make sure you understand them thoroughly.


Starting with your gross income from all sources, determine how the income numbers on your tax return were calculated. Your gross income would include:

  • Your gross annual salary including bonuses and commissions (before any deductions)
  • Interest income, whether taxable or tax-exempt
  • Dividend income, both qualified and non-qualified
  • Capital gain distributions and stock sales
  • Rental or business income

In order to understand the difference between your gross salary and the wages you report on your tax return from your W-2, box 1, use the same formula that we used when discussing withholding in mini-class TX302: Payroll Withholding Tax Basics.

Interest, dividends, and capital gains are fairly straightforward. Rental or business income will require you to look at the respective forms (Schedule E and Schedule C) in order to see the related deductions. If you have a rental property with passive losses that aren’t able to be deducted on your return, you may also need to follow some additional forms to understand how the limitations are imposed.

Let’s say that you keep meticulous track of your income and expenses with YNAB (you’re my new BFF!). During the year you have recorded the following income items:

  • Annual gross salary of $100,000 (because you track your payroll deductions separately)
  • Interest income of $350, $100 which is from municipal bonds
  • Dividend income of $1,800, all qualified
  • Proceeds from the sale of stock $1,500 (original cost was $1,000 purchased 5 years ago)
  • Sale of items on Craigslist for $1,300 total throughout the year
  • Gifts from parents of $5,000

First of all, to match your salary to your tax return, you will first need to make some adjustments.

  • Annual salary $100,000
  • Less: Medical insurance premiums ($3,000)
  • Less: Retirement contributions ($5,000)
  • Less: HSA/FSA/DCA contributions ($3,000)
  • Plus: Taxable fringe benefits – life insurance over $50,000 provided by employer +$50

Wages on W-2 line 1 is equal to $89,050.

Interest income to be reported on the tax return is $250 (with $100 reported for information purposes). The full $1,800 of dividends will be reported on the tax return as well as the stock sale, which will show up as a long-term capital gain of $500. The Craigslist items are not taxable, assuming that you purchased those items in the past for more than you are sold them for. In addition, the gifts are not taxable to you either. The total income is, therefore, $91,600.

You can see here that contributing to tax-advantaged accounts through your employer is a great way to reduce your income on your tax return. The current limit on 401(k) contributions is $18,000, with a $6,000 catch-up contribution allowed for those 50 and over. The current limit on HSA contributions is $3,400 for single filers and $6,750 for married filers filing jointly, plus an additional $1,000 for those 55 and over.


Some of the most common above the line deductions include:

  • Traditional IRA deduction
  • HSA deduction
  • Student loan interest deduction (this is limited to $2,500 and phases out at $160,000 if married filing joint or $80,000 if single filing)

As you can see, aside from your employment accounts, there are other opportunities to reduce your income further by taking advantage of contributing to pre-tax IRA and HSA accounts.

The great thing about IRA and HSA contributions is that the deadlines to contribute for the tax year are not until April 15th (this year April 18th) of the next year. That means that you can complete your entire tax return and then look at the impact of making the contribution.

In our example, we’ll assume that you have paid $630 in student loan interest and are interested in making an additional Traditional IRA contribution in the amount of $1,500 for a spouse who isn’t covered by a workplace plan.

At this point, you’ve arrived at your Adjusted Gross Income, which is calculated as total income minus the above the line deductions.


What benefit are you really getting, if any, in being able to itemize your deductions if you currently do so? You should compare the standard deduction to the amount of itemized deductions you have claimed.

The standard deduction for 2016 is:14

  • $6,300 for single filers
  • $9,300 for head of household filers
  • $12,600 for married couples filing jointly

In the example, let’s assume that you own a home and have itemized deductions in excess of the standard deduction amount.

  • $3,000 state taxes
  • $7,500 mortgage interest
  • $3,500 real estate taxes
  • $200 personal property taxes
  • $750 charitable contributions

The total itemized deductions are $14,950 which is higher than the standard deduction. Note that it is only $2,350 higher than the standard deduction for married filing joint couples, so there is only a small benefit being derived from being able to itemize deductions.


Unless your personal exemptions are being phased out (those with income over $311,300 if married filing jointly), you should have exemptions in the amount of $4,050 per person. This is an additional amount that shelters part of your income from tax, based on the number of people in your household.

After subtracting your personal exemptions, you’ll reach your taxable income.

Let’s assume in our example that you have two children. Your total personal exemptions will be $4,050 x 4 people = $16,200. After subtracting the itemized deductions and personal exemptions, this brings us to $58,320 of taxable income.


This is the point where you need to understand how the graduated tax system works to arrive at your marginal tax rate. Understanding your marginal tax rate is essential to be able to implement tax planning.

Your marginal tax rate is the percentage of tax you will pay on your next dollar of regular income. Your first dollars of income are taxed at only 10%, then at 15%, then 25% up to 39.6%. Even those with high income still are able to get their first dollars of income taxed at 10%.

In addition, the tax code allows for lower tax rates on qualified dividends and long-term capital gains. These preferential income items are taxed at 0% for those that are in the 10 or 15% ordinary income brackets, 15% for those that are in the 25, 28, 33 and 35% brackets and 20% for those in the 39.6% tax bracket.

Here are the tax brackets including capital gain tax rates for 2016.

2016 tax brackets

First, you “fill up” the tax brackets with ordinary income, then determine how much of that bracket left have to fill up the brackets with preferentially taxed items at the preferential tax rate.

Let’s go through our example. We will assume that you are married filing a joint return. Your taxable income, as calculated in the steps above, is $58,320. $56,020 is ordinary income and $2,300 is qualified dividends and capital gains taxed at preferential rates.

The first $18,550 of this ordinary taxable income is taxed at 10% ($1,855 in tax)

The remaining $37,470 of this ordinary taxable income is taxed at 15% ($2,838 in tax)

Next, we need to look at the qualified dividends and capital gains. Since you are still in the 15% bracket (total taxable income of $58,320 is less than the $75,300 threshold) the rate that applies to your qualified dividends and long-term capital gains is 0%.

In the example, we would show a total tax amount of $4,693. Alternative minimum tax would definitely not be owed for an individual at this income level.


A credit is worth more than a deduction in real amounts because it represents an actual reduction of tax dollar for dollar, unlike a deduction which represents lowering the amount of income subject to tax.

Some typical credits include:

  • Child dependent care credit
  • Child tax credit
  • Residential energy credit

These credits all have different rules, as well as income phase-outs. For example, if your income is higher than around $45,000, you’ll only be able to take 20% of your childcare expenses up to $3,000 for one child or $6,000 for two or more children for the child dependent care credit. The child tax credit starts to phase out at $110,000 of income for those married filing joint returns.

In our example, we’ll assume that you are able to take the child tax credit for each of your two children in the amount of $1,000 each. So, your total tax credits are $2,000.

After credits, our example shows that only $2,693 is due for total federal taxes.


You may find yourself owing some additional taxes, such as self-employment taxes, health care individual responsibility and others. Make sure you know how these are calculated and whether you can minimize them in future years.


There are many benefits from going through and understanding your tax return (especially the marginal tax rate!). Some include the following.

  • You will have an understanding of whether any deduction items are being “phased out” due to your income or other factors
  • You will be able to optimize your income or other tax items to ensure that you are paying the lowest tax rate possible
  • You may choose to increase your contributions to tax-advantaged accounts
  • You will be able to plan ahead for next year, having more confidence
  • You will be able to complete your own quarterly tax estimates
  • You may even be able to complete your own taxes, saving you money

Tax planning opportunities become more and more valuable as you make more income and are subject to higher tax rates. If you’re not making a high income now, it’s the perfect time to start learning about taxes so that you will be confident in your ability later. If you do have a high income already, knowledge is power to be able to reduce your tax burden. 

You’re the one with the power over the income and deductions, so even if you hire someone to prepare your taxes for you, it’s still important to know how it all fits together!


8 Responses

  1. Nice summary! One of the best things I ever did for myself was fill out a paper return for myself instead of using software one year. You really ‘get it’ when you have to manually add and subtract each number and look up your tax on the tax tables.

    1. Yes-marginal tax rates aren’t a complicated topic, but how it works just doesn’t really “click” until you calculate the numbers yourself.

  2. “Next, we need to look at the qualified dividends and capital gains”

    I suppose more dividends and more taxes to pay on them is a good problem to have lol. As Ric Edelman says, if your paying taxes, your making money! I agree there are a lot of benefits in understanding all the deductions and credits. As you move forward in your career, it becomes more important to do so.

  3. Luckily the tax system here in Australia is really simple. It only takes an hour to go through the entire form, which is online on the government’s website. It’s just a bunch of drop down menus and it doesn’t have a ton of lines like the U.S. has.

  4. This was a really well thought out guide, I’ll definitely make sure to keep it in mind next time I hear someone talking about taxes.

    I agree that for those of us who are really in to personal finance this stuff is interesting, but I like the way you broke it down and it’s something I think once someone reads through and tries they’ll find it’s really not rocket science. One hidden nugget I found was that at the very least doing your own taxes (and going through the various forms) could be great motivation to simplify one’s finances – consolidating accounts, getting a system together for recordkeeping, and tracking income.

    1. I’m all about figuring things out for yourself and that definitely leads to having a great financial process. It makes all the difference!



I’m Kathryn Hanna-wife, mother of 3 and a Certified Public Accountant. I love to budget (really, I do!) , build spreadsheets and spend money on travel, sewing supplies and good chocolate.


12 Month Financial Plan Sidebar


Easy-to-customize spreadsheets to improve your entire financial life from budgeting to tax and retirement planning.