[Editor's Note: This is a guest post from Preeti Shah, CPA, CFP. Preeti is the owner of Enlight Financial MD where she does financial planning for physicians and is an advertiser here at The White Coat Investor. In this post Preeti discusses the importance of actually having a clue about what is going on every April 15th. I couldn't agree more! Bear in mind this was submitted months ago, long before Congress even started working on the bill they will likely pass this week. The only thing I noticed reading briefly through the post this week was that moving expenses aren't going to be a deduction after 2017.]
The tax extension deadline is approaching and I just spent 2 hours today with yet another physician explaining to them their own tax return. Yes, it actually took that long, and no, neither he nor I prepared it – it was filed by a tax professional who has been doing his return for years. And yet again there were deductions that were forgotten, carryovers that were dropped, and numbers that could be audit flags. A few of these were the fault of the preparer, and a few the fault of my client.
So I thought I’d take the time to explain to those of you on WCI how to understand your own tax return, even if you have a professional who prepares it for you. It might be a dry few hours of learning, granted, but once you’re done, you’ll know how to read and understand your own tax returns for life. Again, let me emphasize that I am not saying you must PREPARE your own tax return. It’s great if you can, but many physicians are too busy and have too many complications on their returns to do it themselves. However if you don’t do it yourself, it is imperative that you UNDERSTAND what is being filed on your behalf.
While I can’t fit everything I’d like to teach you into one article, I will do my best to highlight the major points – here goes:
Understanding the Basics of Your Tax Return
The 1040 Form
The 1040, your personal tax return, is the ocean into which all rivers flow (Forms, Schedules, K-1s, 1099s, W-2s).
Did you know that the 1040 is, in fact, only 2 pages long? It starts on page 1 with your name and ends on page 2 with your total refund or tax due, along with your signature.
This might be obvious to many of you, but surprisingly, I was a CPA and Auditor for 20 years and even I didn’t realize this until I started reviewing tax returns as part of my practice. Once you grasp this, following the logic of your return becomes much easier.
Major Sections of the 1040:
- Identification Info: Name, Address, Filing Status, and Dependents
- Income: W-2, 1099, Passive, Business, IRA, Dividend, Interest, Unemployment, Pensions, etc.
- Taxes and Credits: Student Loan Interest, Moving Expenses, Childcare, Itemized Deductions, and more
- Payments and Refunds: How much tax you’ve had withheld already, and a final calculation of what you owe or will receive back
The Rest of the Return Is to Support the 1040
The rest of the 50-75 page tax returns simply consists of supporting forms, schedules, and documentation for those first 2 pages.
A Few Examples:
1. Line 7, “Wages, Salary, Tips, etc.” (on page 1 of your 1040): This number comes from your W-2.
2. Line 8a, “Taxable Interest”: This comes from your 1099-INT or Schedule B if you have multiple 1099-INTs.
3. Line 12, “Business Income (or Loss)” or Line 17, “Rental Real Estate, Royalties, Partnerships…”: These are supported by the rivers named Schedule C or Schedule E. These schedules are further supported by smaller rivers, or streams (like your K-1s). Hopefully all your business information is further supported by your Quickbooks or accounting system, which are supported by your credit card and bank statements, and further supported by actual receipts. Here's how that looks:
Receipts, Invoices –>Credit Cards –>Bank Statements –> LLC –> K-1 –> Schedule E –> 1040 line 17
4. Line 40, “Itemized Deductions”: This line of your 1040 “ocean” is fed from the river named Schedule A. This is where you list familiar deductions like Charitable, Medical, and Mortgage Interest.
How to Review and Understand Each Line on Your Tax Return
What I would recommend is separating the main two pages of your 1040 from the rest of your return, and then start line by line and understand where each number comes from. If the supporting document is coming from somewhere OUTSIDE the tax return like a 1099, it might not reference it.
But if the supporting document is WITHIN the tax return, such as an attached schedule or form, it should reference it (i.e. Schedule D or Form 8917). If it references a form or schedule, simply go to that part of your return, and then logically trace everything that was done there. The final number on that form or schedule should tie back up to the main 1040. Once you check that form or schedule, put it to the side or mark it as “reviewed” and then go back to the 1040 and continue your journey on down the page. When you reach the end of those 2 pages for your 1040, you should have also reached the end of reviewing all the other pages behind it.
Then I would recommend a second session, where you go back and review the 2 pages of the 1040 in general, not just for the line items where you have numbers filled in, but for the blank lines as well. My client had only 20 of the 79 line items filled in. But we discovered another few that might apply to him, such as moving expenses and the foreign tax credit for a property he has abroad. These were not explained to him as a possible deduction by his tax preparer.
Stay Vigilant, It's Your Money
Unfortunately, most tax preparers are crazy busy during tax season, and they don’t take the time to walk you through all the possible deductions for which you might be eligible. CE classes, tax preparation fees, childcare, mortgage insurance premiums, uninsured flooded basements – these are common omissions I’ve seen. Many of you won’t be eligible for these because your income levels are too high, but that doesn’t excuse the tax preparer from not asking you about possible deductions anyway.
So take it upon yourself to read all 79 lines on the 2 pages of the 1040, and to generally understand the deductions and credits you are allowed. That will help you trigger your memory for anything you might have forgotten to take. I would also advise going through Schedule A as well – it’s only one page but it lists common deductions to which you may be entitled. If you can understand those 3 pages, you’re halfway there.
One other parting suggestion is to also track your own carryovers, such as any capital losses, real estate losses, business losses, accumulated depreciation, AMT credits, or other types of deductions that may not have been allowed in previous years, but can possibly be used in your current or future years. I have seen careless preparers who are working with a new client forget to transfer a carryover from an older tax return to the new one. It doesn’t happen as often when you’re with the same preparer for many years, but it can occur, so stay vigilant.
It’s your hard-earned money, and you have the right to take every legal deduction available to you. But I advise you not to depend on someone else to be your watchdog – you are your own best advocate and should always perform the final quality control check.
What do you think? Do you prepare your own taxes? How did you learn to understand the 1099 and it's forms, schedules, and documentation?