Tax Basics: The Personal Tax Return (1040)

Okay, let's now jump into your personal tax return. We've spoken a lot about the corporate tax return, about some of the key features of the corporate tax return as they relate to dentists. Let's now dive into that personal tax return. And as I've stated before, the tax tax code is incredibly complicated, far more complicated than it probably should be. But one thing that the IRS has done is they've sifted everything down ultimately to one simple page on your 1040. Now there's schedules and addendums and all sorts of supporting numbers behind what ultimately lands on this page page of your 1040. But for you as a non tax professional, but as a business owner, I do want you to understand sort of this distilled down version of what the tax code entails to you. So let's look at your 1040. There are only a few rows. Now let me emphasize this changes and this changed recently with the Trump. The Trump tax change changes and dramatically change the 1040, which hadn't been changed like this in a long time, but it changed it. And could it change again? Absolutely. But this is what it looks like right now. At the top you have all your basic information of name and address, etc. You have your dependents which are going to be your children. And then you are going to start off in box number one indicating what are your wages, salaries and tips. This is what shows up on your 1040. And as I've stated for most of you that are corporations, you're going to get a W2. Now, even if you are a partner in a partnership, generally speaking, we recommend as many dental attorneys will as well that your partnership be owned by your own, by each doctor's own corporations. So if you have two doctors, the Dr. A may own 100% of his or her corporation, Dr. B would own 100% of his or her corporation, and they would have things like their own W2 taking place in those corporations and they would own their share, let's say 50% each in the partnership which files its own tax return and every month or periodically will make a distribution of its income and its cash or over into your corporations. So even if you're a partnership, it's very likely, if you've set yourself up as a, what's called a partnership of corporations, which is this sort of structure, then you're still going to get a W2 at the end of the year. Partnerships don't pay a W2 to their owners, they just distribute profits to their owners. If you own a corporation, those profits are distributed to the corporations where you then will run a W2 for yourself. Now, there's a number of reasons to set that up as a separate corporation, and I won't go into that here. But my point is, is that whether you're, whether you're a partnership of corporations or for most of you are going to own your own practice as an S corporation or an LLC filing as an S corporation, you're going to pay yourself a W2 every year. And remember, you have to, because the IRS only gets their Social Security and Medicare. As of now, as of 2020, that could change. But they only get that when you pay yourself a W2. And the K1 coming out of your corporation to yourself personally isn't subject to FICA taxes, Social Security, Medicare taxes. And so you have to have a W2 at a certain level. And I would work with your tax CPA or with your practice CFO advisor to define what, what's the right level of W2 for you and your tax planning. So whatever W2 you end up paying yourself from your corporation, that income is going to show up on the W2, which is then going to show up here on box one of your 1040. If your spouse is working as well, either in your corporation or for some other unrelated employer, his or her income will also show up in box number one. So you see that I have.

The wages, salaries and tips boxed here in red with the arrow showing W2 from your 1120s, which is your corporate tax return. Now, if we skip down, there's going to be some other areas on here from qualified dividends, if you own stocks and bonds outside of a taxable, outside of a tax deferred retirement account.

If you're receiving Social Security or if you have pension from, from a large, you know, from a company or annuities, you're going to have other forms of income. But for you young doctors, this is the Associates on Fire program. Most of you are not at that point where you've got dividends coming in from taxable accounts and you've got Social Security and pensions, anything like that, most of that's generally going to be zero. So you got your income in box one, and then you have in box right now, 7A other income from schedule one other income. One of the things in that other income, the main thing for you, and for many of you, the only thing will be the K1 from your 1120s from the prior tax modules. You saw there was this teeter totter, and the teeter totter had your W2 and your K1, if you paid yourself more W2, your K1 went down and vice versa. And it ends up being about the same. And both of those flow through in those first two arrows and in box 1 and box 7A. And they're taxed at the same rate for income tax purposes. Now, there's a lot of reasons why you need to make sure that teeter totter is angled at the right in the right with the right incline or decline or however you structure that. There's really important tax planning implications with that. And that's why we want you to watch our module on how you structure your payroll. But either way, for purposes of understanding the 1040, both the W2 and the K1 flow through on your 1040. And you can see it right there in those boxes. Very simple. The only other thing I really want to show you here then, as deductions you get are you take what is called either the standard deduction or the itemized deduction. It's one or the other. And the standard deduction is the amount given if you simply breathe. If you breathe and file a tax return, then you get a standard deduction. And that's the IRS saying and the government saying, hey, whatever your income is, we're going to let you reduce your income level by this amount when calculating what is your taxable income. It's sort of a gimme. Yep. The IRS gives you a gimme here on the standard deduction. And as of 2020 for married filing joint tax return, that deduction is $24,800. So you get to reduce whatever your income is up above from your W2 and your K1 by $24,800 or your itemized deductions if those itemized deductions exceed your standard deduction. Also relating your standard deduction, if you're single, it's going to be, it's going to be half that. It's going to be $12,400. And this standard deduction changes based on the political wins a little bit. But as of right now, it's 12,004, 800 married filing joists. I mean 24,800 married filing joint, 12,400 for single. And so if your itemized deductions exceed that amount, then you're going to take your itemized deductions because you get a greater offset of your income, a greater deduction. If you can itemize, you'll hear that if you can, am I itemizing my tax return? Well, typically, if you own a house and if you own a house. Oftentimes you're itemized. Not always, but especially if you live in the high real estate cost areas like California, for example, or New York, or a lot of the coastal areas, and you're paying a lot of home mortgage payment and a lot of interest, you might itemize. Why? Because itemized deductions are the following. And I'm really only going to mention those ones that matter most of the time. There's a few others that can be applicable, but most of the time for dentists, these are the only ones that matter. Number one are your state and property taxes. So all that money you're paying to your state for income taxes, guess what? You get a tax deduction for that. So if you live in California, where you've got a 9.3% tax rate, and you're paying quite a bit of money to the state of California, and you get to use that as a deduction or an offset to your federal income tax. Same thing with your home property taxes. Let's say you're paying $10,000 a year in your property taxes, that becomes a deduction against your federal income tax return. But with the new Trump tax code, they capped that to only 10,000 combined state income taxes and property taxes, that used to be unlimited. And in California, I, I would see that getting up to 70, $80,000 and now it's only $10,000. So that limits the benefit that you get or can get out of itemizing deductions. Now, that may change as many things with taxes, that may change. But right now, $10,000. The other thing you get to deduct is home mortgage interest. Now remember, when you make a loan payment, portion goes to principal and a portion goes to interest. And over time, more goes to principal and less goes to interest with every payment. Even though every payment is the same. Well, that interest portion is tax deductible. If you bought a house after 2020, you can deduct up to $750,000 of the purchase price of a home. You can deduct that interest on that portion. But if you bought a home for a million dollars, you're going to end up deducting 75% of the interest you paid for the year on your itemized deduction. So home mortgage interest is the second one. And of course, charitable contributions, they essentially don't have a cap. Now they do, but it's so high that it's really not going to matter for most of you. So if you pay $15,000, $5,000 or whatever, $200 to a qualified charity like a church or some other charitable organization. And you of course, get the receipt from that that they should provide. You provide that to your tax preparer. And, and that's also included in your itemized deduction. So you add up all these itemized deductions and if they exceed your standard deduction, then you are going to take those itemized deductions and that will lower your income. All of those itemized deductions show up on this thing called a schedule a schedule A itemized deductions. And now notice in row number 10, there's this thing called qualified business income deductions. Well, if your combined federal and state income is less than 415,000.

Then you can get a deduction on your K1 income. That K1 that flows through to you on paper that we discuss so much about. You can get 20% deduction on that. That's a benefit that came out of the Trump tax code was this qualified business income deduction. If you end up making more than 415,000 combined income between your W2K1 and other sources and you phase out of that and you don't, you don't get that. And there's other things in here, like child tax credits. If you earn less than a certain amount, around $300,000 or so, then you get $2,000 deduction per child or what's called a credit, actually, which is even better than a deduction because it's dollar for dollar per child. And so there's more that goes into this. But those are the main sort of blocks I want you to understand about the 1040 tax return. Let's look at what the tax brackets are as of 2020. As you know, we're in a country that does not have a flat tax. If I make a lot less than you, I'm not paying the same percentage as you. You're going to pay a higher percentage than I am. The more money you make, the higher percentage you pay. It is a progressive tax system, a tiered or staired tax code. Look on the screen and let's see what that tier looks like. You got 10% all the way up to 37%. Let's look at, let's look at married filing joint, the one in the middle. And if you make between your W2 and your K1 and whatever other sources of income you have, if you made less than 19,700, you're essentially not paying anything. Now, remember, this is the amount. This is the amount after calculating your itemized deductions. And everything. And you finally land at what is your taxable income. And this is what this is what is it's actually at 10% between $0 and $19,750. So the Max you could you would have to pay.

On that is going to be 10, 10% of that $19,750. Now if you end up having a getting a child tax credit or some other credit, maybe you buy an electric car and there's still a tax credit, or you put some solar up and there's a tax credit for that, then you'll be able to eliminate that portion of your taxes equal to the amount of the credit. Credits are really wonderful things because they come dollar for dollar right off what your taxable income, what your taxes end up being. But here's what I really want to emphasize is as you continue to go up and now you're making more than 19,750 and then you're making more. If you look at that middle column, third line, now you're making more than 80,251. Now you're making more than $171,051. And you keep going up and up and up. Look at the rate. The rate continues to climb. Here's something that a lot of people get confused about. Let's look at an example.

Actually, before we get to the example, let me explain that the bracket that you're in, the bracket where your next dollar of income is, that's called your marginal tax rate, the tier in which your next dollar of income is taxed or your next dollar of expenses is deducted. So if you're in December and you're almost through the end of the year and you decide I'm going to go pay $20,000 to buy a lot of supplies for my practice, that $20,000 is going to be deducted at whatever tax tier or bracket that you're that you're projected to be in. So if you're projected to have a taxable income of $500,000, you are in the 35% tax bracket. And if you pay for that $20,000, you're most likely going to get a 35% tax break or a deduction on that 20,000. Now, if your projected income is only 150,000, so look on that married filing joint middle column tax scale, 150,000, that's going to be your third row there. You're only going to get a 22% tax benefit for going and buying those supplies near the end of the year whenever you're tax planning. You always tax plan on the margins. Where am I projected to be at the end of the year based on where I'm going and what tax tier or step am I going to be in? Because then if I set up a 401k or I accelerate some depreciation or I buy more supplies, or I do this or that, that is the rate at which you're going to get that tax benefit. It's also the rate if you decide to take on a new big case or you end up getting more income than expected, that that new dollar of income is going to be. And I've had a lot of people say, wes, I don't want to go work harder and earn more because the IRS is taking so much at that point. Well, there's some truth to that, but remember, you're always taking home the larger share at the end of the day. But the marginal value back to you does go down a little bit as your income goes up because of the increase or the nature of the tax scale. This is why tax planning is so essential in the overall context of your cash flows and that you have somebody who understands dental practice cash flow. And in order to tax plan effectively for you, it'll save you incredible amounts throughout your career and will dramatically affect your ability to become financially independent and retire. So that's your marginal tax rate. It's the tier that you're, that you end up being in when you file your tax return. Your effective tax rate is just your average tax rate. It's your total taxes divided by your total income. And let's look at now our example. Let's say we've got married filing joint, and your taxable income is projected to be 300,000. Or you know what, let's say the year is over and that's actually what your income is. You're at $300,000 of income. That's your W2 might have been 150,000, and your K1 might have been another 150,000. So you're at $300,000.

And your taxes on that are $6159. That's how much you have to pay to the IRS because of your $300,000. Well, let me ask you, what's your marginal tax rate? You can see it right there on the screen. Your marginal tax rate at 300,000 married filing joint is 24%. Look on the middle column, find where $300,000 lands. Look to the left and you'll see that your marginal tax rate is 24%. Now, what's your effective tax rate? Your effective tax rate is simply what you paid in taxes divided by your income. $60159 divided by $300,000 is equals rounding 20%. That is your effective or your average tax rate. Notice that your average or effective tax rate is less than your marginal tax rate. And unless you're in that first tier of 10%, that will always be the case. And the reason why is that just because you're in the $300,000 income range doesn't mean that all of your income is taxed at 24%. All it means is that anything above $171,000. Again, look at that middle column and look at the fourth row where 300,000 fits in between 171,000 and 326. Anything above the 171,501, that's taxed at 24%. But everything below that leading up to the 171,000 is taxed at those lower tiers. So your first 19,750 is taxed at 10%. After that, you've got roughly $60,000 between 19, 7, 51 and 80,250 that's taxed at 12% and so forth on the 22%. So that's why your effective or average tax rate ends up being less, because you get to use all those lower tax scales in arriving at your marginal tax rate or that ultimate tier that you land in. And that's how a progressive tax system works. How is this relevant to you? Because you always need to be doing tax projections and planning to understand what tax bracket are you going to be, are you going to end up in to decide what should I be doing and how aggressively should I be doing that, that tax planning strategy in order to save my taxes at that highest tax rate. So we're going to now be talking about tax planning in our next module.