The topic I learned the most about when studying for Certified Financial Planner (CFP) certification was tax planning. As I began working with clients, I realized this is the area I had the most to continue to learn if I wanted to truly master it. So I recently took Part 1 of the IRS enrolled agent (EA) designation to bolster my tax knowledge.

In my CFP curriculum, our instructor emphasized building from a solid foundation. He repeated the mantra “Know the flow, get the points.” “Know the flow” was shorthand for understanding the flow of information on IRS Form 1040.

The EA review course I took started with the same foundation. It used the analogy comparing Form 1040 and its corresponding schedules to a jigsaw puzzle. Trying to understand tax without “knowing the flow” is like doing a puzzle without seeing the picture on the box.

This framework of following the flow of Form 1040 helps simplify taxes. It is a foundation for understanding the federal income tax system, allowing more complex tax planning.

Start by Determining All Sources of Income

Before we get to Form 1040, we need to consider all of our potential sources of income. In IRS Publication 525, Taxable and Nontaxable Income income is defined as follows: “You can receive income in the form of money, property, or services.” Publication 525 explains that all “income is taxable unless it is specifically exempted by law.”

All taxable income will be reported on Form 1040 and is subject to tax. Some nontaxable income may also have to be reported on your return.

Publication 525 is not recommended reading! The key take-home point is essentially all income must be considered. There is even an explicit requirement to report income from illegal activities.

Subtract Exclusions from Income

The next step is the most challenging in understanding “the flow.” An exclusion is a source of income treated as nontaxable and thus excluded from the tax base. I’m not aware of any easily readable and searchable reference for income exclusions.

It is worth at the very least being aware that:

• Income exclusions exist.
• Common exclusions can present planning opportunities.

Let’s examine some common exclusions you should be aware of.

Common Exclusions

Some common examples of income exclusions include:

• Child support
• Death benefits from life insurance policies
• Gains on the sale of a personal residence
• Gifts (nontaxable to the recipient)
• Health insurance employer-paid premiums and benefits received
• Inheritances
• Interest on Education Savings Bonds (Series EE or I)
• Municipal bond interest
• Scholarships

Note this is NOT a comprehensive list. There are seemingly random exclusions. 

For example, you can rent your home for less than 15 days per year (i.e. the Augusta Rule) with zero tax consequences on that income. So for example, when the Winter Olympics come to my area in a few years I could make $5,000, or even $50,000, renting our home for two weeks during that event. It would be as though it never happened from a tax perspective.

However, if we rent our home for 15 or more nights this year, we would have to report all our income and allocate a portion of expenses, even if we made very little money.

Many Exclusions Are Conditional

In addition to the challenge of knowing what is and what isn’t an income exclusion, many exclusions are conditional.

The tax-exempt gains on the sale of your home are capped at $250k for single filers or $500k for married filing jointly filers. These exclusions require meeting ownership and use tests to qualify.

Related: Will I Owe Taxes When I Sell My Home?

Another example of conditional exclusions is interest income from Series EE and I Bonds. Interest income may be excluded if proceeds are used to pay qualified education expenses. However, you must meet all of the requirements to exclude this income. 

In fact, qualified education expenses have different definitions for interest on US savings bonds (tuition and fees only), scholarships and fellowships (tuition, required fees, books, and supplies), and 529 plan distributions (tuition, fees, books, supplies, and room and board). These definitions are important. They determine whether income spent on these expenses is exempt from taxation.

Income as a result of divorce settlements can be confusing. Alimony may be included or excluded from taxable income depending on the date the divorce was finalized. Child support is never taxable.

Income from a legal settlement after an accident may be excluded from income if the income is compensatory for an injury or lost wages. However, compensation is taxable if it is punitive.

Federal Exclusions May Still Have Tax Implications

You also need to remember there are differences in taxation at the federal and state levels. For example, inheritances and gifts are never federally taxable income for a recipient. However, state tax rules vary, so this income may still be subject to tax at the state level.

Finally, just because income is excluded from income taxation does not mean it does not have federal tax implications. Here are a few common examples to be aware of.

When you utilize a tax-deferred work-sponsored retirement plan your contributions are excluded from federal income tax in the year of the contribution. However, this income is subject to Social Security and Medicare tax. (Even more confusing, employer contributions avoid both layers of taxation in the year of contribution, though federal income tax will ultimately be owed on all of these dollars when money is taken from the account.)

Municipal bond interest is also exempt from federal taxation. However, this income is considered when calculating provisional income. Provisional income determines the percentage of Social Security benefits that are taxed. So while exempt from federal income taxes, municipal bond interest income may have federal tax implications.

Related: How Are Social Security Benefits Taxed?

Determine Total Income (Lines 1-9)

Sorry! Exclusions can be overwhelming.

Now that we’ve briefly covered exclusions, you can follow “the flow” of IRS Form 1040. It is helpful to open Form 1040 in a separate window to follow along as you read. Start with lines 1-9 to determine your total income.

Wages and Other Income (Lines 1a – 1z)

Line 1a is where you report income earned as an employee. This is likely familiar to almost everyone reading this. You find this information on form W-2. Your employer is required to provide this form.

Lines 1b-1i are where you report other miscellaneous income such as income earned as a household employee, tips, and income from certain scholarships and grants.

Investment Income (Lines 2, 3, and 7)

Income reported on Lines 2 and 3 is related to interest and dividend income generated by investments. This information flows through from Schedule B. You find the information to complete Schedule B on Forms 1099-INT and 1099-DIV issued by financial institutions.

Of note here, qualified dividends (reported on line 3a) are a portion of your total dividends (line 3b). Qualified dividends are taxed more favorably, so looking at what percentage of dividends are qualified helps see how tax-efficient your taxable investments are.

Briefly jumping ahead, you report capital gains on Line 7. This information flows through Schedule D, which flows through Form 8949. 

Understanding capital gains provides more tax planning opportunities. The size of your capital gains and why you have them gives information about how tax-efficient your taxable investments are. 

You may understandably incur large capital gains if selling taxable investments to provide retirement income. Generally, you want to minimize capital gains when you don’t need that income in accumulation years because those capital gains create an unnecessary tax drag on your returns.

You can also consider tax loss or gain harvesting opportunities as your situation dictates.

Related: What Story Is Your Tax Return Telling?

Retirement Income (Lines 4-6)

Jumping back up in the flow, you report retirement income on lines 4-6 of Form 1040.

Retirement Accounts

Line 4 is used to report distributions from IRAs and Roth IRAs. Line 5 is used to report distributions from pensions and annuities. This includes workplace retirement plans like 401(k), 403(b), and 457 accounts.

This income is reported to you on form 1099-R issued by financial institutions. Lines 4a and 5a are where you report tax-exempt distributions. Lines 4b and 5b are where you report the taxable portions that factor into your total income.

Social Security

Line 6a is where you report total Social Security income. A portion of your benefit, ranging from 0-85% is taxable. Line 6b is used to report the taxable portion.

Related: How Are Social Security Benefits Taxed?

Additional Income (Line 8)

Line 8 is used to report any additional sources of income. This information flows through Schedule 1, Part I.

Several sources of income are reported on Schedule 1. Most notable are profit or loss from business/self-employment (flowing through from Schedule C) and income or loss from real estate, royalties, partnerships, S corporations, estates, trusts, etc (flowing through from Schedule E).

Total Income (Line 9)

After completing all the necessary schedules and entering income on Form 1040, Line 9 is used to record the sum of the income from these sources. The result is your total income.

Subtract Adjustments to Income to Determine AGI (Lines 10-11)

You subtract adjustments to income, commonly referred to as above-the-line deductions, to arrive at your adjusted gross income (AGI). The adjustments to AGI are found in Part II of Schedule 1. 

Some of the more impactful deductions to decrease AGI include contributing to HSA and Traditional IRA accounts. The self-employed can also deduct health insurance premiums, a portion of self-employment tax, and contributions to self-employed retirement plans to lower AGI.

AGI (or Modified AGI) determines eligibility for various benefits. These benefits include eligibility for various tax credits and whether you can deduct a traditional IRA, contribute to a Roth IRA, or will be subject to IRMAA. So understanding the exclusions and above-the-line deductions that reduce AGI is an important element of tax planning.

Related: How to Calculate AGI and MAGI and Why It Matters

The sum of the deductions is entered on Line 10 of Form 1040. This number is then subtracted from total income to arrive at AGI on Line 11.

Subtract Below the Line Deductions to Arrive at Taxable Income (Lines 12-15)

From AGI, you first subtract either the standard deduction or the sum of your itemized deductions, whichever has the greatest impact on decreasing your taxable income. This is a year-to-year decision. Whichever option you choose, the amount is recorded on Line 12.

You can itemize one year and take the standard deduction in others. One tax strategy could be to bunch itemized deduction items, most commonly charitable giving, to get a large deduction in one year to your benefit. Then use the standard deduction in other years.

Standard Deduction

There are scenarios where you may not be able to use the standard deduction. One example is if you use the married filing separately filing status, both partners must either itemize or take the standard deduction.

The size of the standard deduction is based first on your filing status. It is largest for married filing jointly, then head of household, with the smallest standard deduction for single filers.

You also get an additional deduction for each filer that is age 65+ or blind. If you are both 65+ and blind, you each get to take both additional deductions.

The additional amount is $1,950 for single and head of household filers and $1,550 for each qualified married filer, whether filing jointly or separately in 2024. This amount adjusts for inflation each year.

Itemized Deductions

Itemized deductions are found on Schedule A. The most common itemized deductions are:

• Medical and dental expenses (>7.5% of AGI),
• State and Local taxes (commonly referred to as SALT) up to $10,000 (unless using the married filing single status in which case you are limited to $5,000),
• Interest paid on up to $750k mortgage debt to buy, build, or improve a primary or second residence as well as interest on investment debt, and
• Charitable giving (subject to limits based on your AGI).

Regardless of whether you itemize or use the standard deduction, you may also take the qualified business income deduction if eligible. This occurs on Line 13. This deduction is calculated on Form 8995.

These below-the-line deductions are less valuable than above-the-line deductions. This is because they do not impact your AGI. However, above and below-the-line deductions equally impact the amount of income that is directly taxable.

Line 14 is the sum of these below-the-line deductions. Subtract the sum from AGI to arrive at your taxable income on Line 15.

Taxable income is the base on which progressive tax rates are applied. It also determines the tax rate applied to your qualified dividends and long-term capital gains.

Tax and Credits (Lines 16-24)

This takes us to the second Page of Form 1040. Here we calculate our tax and apply any nonrefundable tax credits to arrive at our total tax.

Tax (Lines 16, 17, and 23)

Line 16 is for reporting income tax from various sources. Ordinary income tax, tax on qualified dividends and capital gains, and foreign earned income tax are included in this number.

Most people use tax software to calculate this number. If you’ve never done it before it is worth looking at the worksheets included in the Form 1040 instructions to “see how the sausage is made.”

Tax on a dependant child’s investment income is also reported on Line 16 if you elect to do so. You would then file Form 8814. Alternatively, if it is more advantageous, you could use Form 8615 to calculate tax on the child’s investment income if having the child file a separate return.

Line 17 flows in from Part I of Schedule 2 where you report tax from two sources that may be of interest to blog readers. One is the alternative minimum tax (AMT) calculated on Form 6251.

The other is excess advance premium tax credit payment for those who purchase health insurance through the ACA exchange. This is calculated on Form 8962. If you underestimate income and receive too large an advanced credit, you owe that back in the form of tax when filing your return.

Related: Maximize ACA Subsidies and Minimize Health Insurance Costs

Quickly jumping ahead, on line 23 you enter “other taxes” that flow from Part II of Schedule 2. This includes, but is not limited to, self-employment tax, additional taxes (commonly thought of as penalties) for non-qualified withdrawals from IRAs, HSAs, and other tax-favored accounts (flowing from Form 5329), additional Medicare tax (flowing from Form 8959), and net investment income tax (flowing from Form 8960).

Nonrefundable Credits (Lines 19-20)

Line 19 is used to enter your child tax credit or credit for other dependents if applicable. Information on Line 20 is the sum of other nonrefundable tax credits. This information flows through from Part 1 of Schedule 3.

Before moving on there are a few things to understand about nonrefundable credits. The first is a definition.

A nonrefundable tax credit reduces your tax dollar for dollar until you eliminate income tax liability. However, if nonrefundable credits are greater than the tax owed, you don’t get any further benefit (i.e. they don’t produce a tax refund).

Another thing to note is that many of these credits have income limits or phaseouts. This is beyond the scope of today’s post. In an upcoming post, I’ll cover tax credits that could benefit early retirees or semi-retirees with relatively low incomes after leaving the full-time workforce.

Calculating Total Tax (Lines 18, 21, 23 and 24)

The lines I skipped in this section are where you do the math to determine your total tax.

Line 18 is simply the sum of income tax from Line 16 and additional tax owed as a result of AMT and/or required repayment of excess ACA premium tax credits from Line 17.

Line 21 is the sum of all refundable tax credits entered on Lines 19 and 20. Refundable credits are subtracted from tax and entered on line 22. If refundable credits exceed tax, you enter 0 indicating no income tax is owed.

Other taxes from Line 23 are then added to Line 22 to arrive at your total tax on Line 24. Note this is NOT what you owe. There is still one more step of applying payments and refundable tax credits to arrive at your tax owed or refund due.

Payments (Lines 25-33)

Income tax in the United States is a pay-as-you-go system. You can’t wait until the end of the year, figure out what you owe, write one check, and call it a day. 

Related: Do I Need to Pay Estimated Quarterly Taxes in Retirement?

Line 25 a-d is where you report income you had withheld. On Line 26 report the estimated tax payments you made during the year.

Lines 27-31 are used to enter any refundable tax credits you are entitled to and payments you made or had withheld throughout the year. In contrast to nonrefundable tax credits discussed above, if your refundable credits are greater than your tax liability, you get that amount back as a refund.

Like the nonrefundable credits discussed above, refundable credits are generally impacted by your income (AGI or Modified AGI) and may present planning opportunities for lower-income early retirees and semi-retirees. 

They include the earned income credit (Line 27), additional tax credit (Line 28), and American opportunity credit (Line 29). 

Information from Line 31 flows from Part II of Schedule 3. Of note, this is where you net your ACA premium tax credit against what you actually owe. You get a refund if you over-reported your income and got too small of a prepayment (i.e. the opposite of the calculation on Line 17 for those that under-reported income and got more credit than they should have).

On Line 32 you add all of these refundable tax credits and other payments from lines 27-31. This is then added to the sum of all your withholding and prepayments from lines 25 and 26. The result is your total payments.

Determine Your Tax Refund or Amount Owed

We’re finally getting close! The final step in the tax flow is to determine if

• You are entitled to receive a refund, or
• You owe tax.

Refund

If Line 33, your total payments, is greater than Line 24, your total tax, you overpaid and/or over-withheld throughout the year. You are entitled to a refund from the IRS.

You can receive your refund in various ways, including by:

• Check
• Direct deposit to a bank or financial institution including checking and savings accounts, IRAs and HSAs.
• A treasury direct account to buy I Bonds (up to $5,000 per return beyond the normal annual limits).

Related: I Bonds vs. TIPS

Many of these refund options require filing Form 8888.

Amount Owed

If Line 33, your total payments, is less than Line 24, your total tax, you owe the IRS money.

You may have been surprised to learn the number of options to receive a refund. You likely aren’t surprised that the IRS offers many ways to pay your taxes! They include:

• Cash, check, or money order,
• Credit or debit card,
• Wire or direct pay from a bank account, and 
• Payments from digital wallets.

You can get an automatic six-month extension to file taxes by filing Form 4868. Note this is NOT an extension to pay your taxes.

If you fail to pay your tax by the due date, April 15th for most taxpayers, or if you have not been making regular payments throughout the year you may be subject to a late payment penalty. This can be true even if you are entitled to a refund after filing taxes if you failed to pay on time throughout the year.

Understanding the Tax Code

I have always found our tax code to be complex and confusing. In the first decade of my adult life, my wife and I paid hundreds of thousands of dollars of tax before we developed even an elementary understanding of how our income was taxed. 

This led to expensive mistakes. However, two positives came out of that experience.

First, as I educated myself, I was able to relate to other people’s lack of understanding and communicate clearly in a way others were able to understand. I’ve received tremendous feedback about the tax chapter in my Choose FI book. That chapter is excerpted here.

Second, my prior mistakes gave me an abnormal interest to continue learning more about taxes, which most people find boring. This was the area I enjoyed the most when taking CFP coursework and what drew me to take the EA exam.

Let me know what you did, or did not, find helpful about this framing of the “tax flow.” I would also love to hear what areas of tax planning you would like me to explore in future blog posts as I continue to explore the topic of tax planning.

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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. After achieving financial independence, Chris began writing about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. Chris also does financial planning with individuals and couples at Abundo Wealth, a low-cost, advice-only financial planning firm with the mission of making quality financial advice available to populations for whom it was previously inaccessible. Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He has spoken at events including the Bogleheads and the American Institute of Certified Public Accountants annual conferences. Blog inquiries can be sent to chris@caniretireyet.com. Financial planning inquiries can be sent to chris@abundowealth.com]

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