01 October 2017
IRS Form 1040 (the individual tax return) can be monstrous to understand if you try to take it in all at once. That’s how most people do it, though. Once a year they look at their entire tax return, get confused and frustrated, and then ignore it for another year.
It’s important for your overall financial well-being to understand your taxes, so let’s look at just a piece of the tax return today. A small bite we can comprehend in one sitting. Specifically, we are looking at the section at the beginning of the form where all your income is listed. Even more specifically, we are going to look at the income line items that are split into segment a and segment b.
If you use tax software to prepare your taxes you might not have noticed some of the income categories are split into two parts. It is much more apparent if you look at the form 1040 income section.
• Line 8a is for taxable interest and line 8b is for tax-exempt interest.
• Line 9a is for ordinary dividends and line 9b is for qualified dividends.
• Line 15a is for IRA distributions and line 15b is for the taxable amount of the IRA distribution.
• Line 16a is for pensions and annuities, and line 16b is for the taxable portion of the distribution.
• Line 20a is for your Social Security benefits received, and line 20b is for the taxable amount of your Social Security benefits.
If It’s Tax-Exempt, Why Do I have to List It on My Tax Return?
The answer to that (very reasonable) question varies with the source of the income. Get comfortable while I explain it to you.
Line 8 Interest Income. Interest income typically comes from the interest on your bank accounts, or from owning bonds. Some interest, such as the interest on municipal bonds (bonds issued by city and state governments to raise revenue), is not taxed by the federal government. If you have interest income over $10 you should be issued a 1099-INT from the institution holding your account(s). The 1099-INT will tell you how much of your interest is taxable and how much in tax-exempt. The reason you must report tax-exempt interest is it might influence your tax situation, even if it isn’t being taxed directly. (Such as when figuring how much of your Social Security is taxable. More on that later.)
Line 9 Dividend Income. Dividends are paid by stocks and mutual funds. Virtually all dividends are known as Ordinary dividends. This amount goes on line 9a. Dividends paid more than 60 days before or after the stock was purchased are known as Qualified dividends. Qualified dividends receive preferential tax treatment – they are taxed at a lower rate than ordinary income. You are being rewarded for assuming the risk of holding the stock for at least 60 days and not just buying right before the dividend is paid and selling right after it is paid. Qualified dividends are a subset of ordinary dividends. The portion of your dividends that are not qualified will be taxed at ordinary tax rates.
Line 15 IRA Distributions. When you take money out of your IRA it is known as a distribution. Your distribution may or may not be taxable. It is usually, but not always, easy to figure out how much of your IRA distribution is taxable. If it came from a Roth IRA, then none of it is taxable. If it came from a traditional IRA where all the contributions were tax deductible, then all the distribution is taxable. Where it gets tricky is when a taxpayer has made contributions to a traditional IRA and did not receive a tax deduction for it. In that case the withdrawal of the contribution is not taxed, but the withdrawal of the earnings is taxable. If you made non-deductible contributions to an IRA you should have been tracking these contributions on form 8606. Dig up your last form 8606 and it should tell you your total IRA contributions, and how much was deducted when the contributions were made.
Line 16 Pensions and Annuities. This is similar to the situation for IRA distributions. If you are receiving a pension or annuity that you paid for, then the portion of your pension that represents your contribution is not taxable. The portion you did not pay for is taxable. My Navy pension is 100% taxable because I did not pay into a pension fund to earn that pension. Federal civilian employees earning a pension under the Federal Employee Retirement System (FERS) are paying into the pension fund. When they receive a payment from the pension fund the portion of that payment that is a return of their contribution is not taxable.
Line 20 Social Security Benefits. One of the most difficult questions clients ask me is how the taxable portion of their Social Security benefits is calculated. There is no simple way to explain it. There are 4 different worksheets used to figure the taxable portion of your Social Security, and you use the one specific to your situation. The shortest answer is that the more income you have from NON-Social Security sources, the more your Social Security benefits will be taxed.
The Reader’s Digest condensed version goes like this: For 2016, if the total of half your Social Security plus all your other income was greater than $34,000 ($44,000 if married filing jointly), then 85% of your Social Security is exposed to tax. All your other income includes your tax-exempt interest. So even though your tax-exempt interest is not directly taxable, it can make more of your Social Security taxable (which is why you have to report your tax-exempt interest, as explained above).
If your only source of income is Social Security, then your Social Security benefits will not be taxed. Unless you are married filing separately and you lived with your spouse for even 1 day. In that case 85% of your Social Security is taxable regardless of your other sources of income. (I think I mentioned that figuring the taxable portion of social security is frightfully complex.)
Congratulations for making it through that article. It was a bit of a slog to write, so it was undoubtedly a slog to read as well. Your commitment to learning about taxes should be rewarded. The first person to tell me they read this entire article will get 50% off their next tax preparation bill at PIM Tax Services. If you have questions, please contact me.