Understanding your tax return

What you'll learn: what an income tax return is actually for, who usually has to file one, and the illustrative tax system this course uses to make the ideas concrete.

This course is general education, not tax advice. Tax rules differ by country and change every year, so for your own return, check with your tax authority or a qualified tax professional.

Meet Leo

Leo is 26 and works as a graphic designer at a small studio, on a salary of $42,000 a year. Last year he also started designing logos for local businesses in the evenings and earned $8,000 from it. He has a savings account that paid $300 of interest, and he paid $1,500 into a personal pension. Until now his employer handled all his tax. This year a friend told him that the side income means he probably has to file a tax return, and he has no idea where to start.

We will follow Leo through every lesson, from his first confused look at the forms to the moment he submits his return and plans for next year.

A word about the system we use

Every country's income tax is different. Rates, allowances, deadlines, forms and even the tax year vary, and they change from year to year. So, rather than teach one country's rules as if they were universal, this course uses an invented, illustrative system with round numbers. It is built from ideas that appear in most income tax systems, but it is not any real country's law. Amounts are in dollars only because they are familiar.

Here are its rules, which we will use throughout:

Whenever we mention a real country, it is labelled as an example, so you can see how the same idea shows up in practice.

What a tax return is for

A tax return is a report you send to your tax authority about one tax year. It does three jobs:

1. It declares your income, from every source the rules say counts.
2. It claims the things that reduce your tax, such as deductions, allowances and credits you are entitled to.
3. It settles up by comparing the tax you owe for the year with the tax you have already paid, usually through your employer, and working out whether you get money back or owe more.

That third job is the one people forget, and it is the key to understanding why returns exist at all.

Settling up after a shared holiday

Think of a tax return as settling up after a shared holiday with friends. During the trip, different people paid for different things: one paid the hotel, another the meals, someone covered the taxis. Nobody knew the final total while it was happening. At the end, you add everything up, work out each person's fair share, and then settle the difference: some people get money back, others pay a bit more.

During the year, tax is collected in pieces: your employer takes some from each payslip, and sometimes banks or clients take some too. Those pieces are estimates. The return is where the real, final figure for the year is worked out, and the estimates are settled against it.

Who usually has to file

In many countries, people whose only income is a salary taxed through their employer never need to file, because the payroll system collects close to the right amount. Others file every year as a matter of course. Common reasons you may need to file include:

• income from self-employment or freelance work, like Leo's logos
• income from renting out property
• significant investment income, or gains from selling investments
• income from abroad
• wanting to claim a refund or a credit that payroll did not account for

A few real-world examples, to show the variety:

These details change, so check your own tax authority's current guidance rather than relying on any table, including this one.

Leo's starting point

Under the illustrative rules, Leo's freelance profit is well over $1,000, so he must file. His deadline is 30 April. He makes a folder and writes on the front what he knows so far:

• Salary: $42,000, with tax already taken by his employer
• Freelance logo work: $8,000 received from clients
• Savings interest: $300
• Personal pension payments: $1,500

He does not yet know which of these count, how they are combined, or what he will owe. That is what the next eight lessons are for.

Recap

• A tax return reports a year's income, claims what reduces your tax, and settles up against tax already paid.
• Like settling up after a shared holiday, it turns a year of partial payments into one final figure.
• Many salaried employees never file; self-employment, rental and investment income often make a return necessary.
• Rules, rates and deadlines vary by country and change often; this course uses an invented system to teach the ideas.

What you'll learn: the main types of income a tax return asks about, why each type is treated differently, and how to work out your total income for the year.

Leo sorts his money

Leo's folder lists four items. His first instinct is to add up everything that landed in his bank account last year. That would be a mistake, in both directions. Some money he received is not income for tax purposes at all, and some of what he received counts only in part. This lesson is about sorting it properly.

Streams feeding one river

Picture your income as streams feeding one river. Each stream comes from a different place: a job, a side business, a savings account, a rented flat. On the return, they all flow into one total. But the tax system cares where each stream came from, because each one is measured, taxed and checked in its own way. Some streams are filtered at the source, some arrive untouched, and a few are not part of the river at all.

The main types of income

Most income tax systems recognise a similar set of categories:

Real systems differ a lot in the details. For example, the UK gives most people a tax-free amount of savings interest, Canada counts only part of a capital gain as income, and Australia gives a discount on gains from assets held for more than a year. The categories, though, are broadly the same everywhere.

What usually is not income

Some money arriving in your account is generally not taxable income for you, although the rules vary:

• Gifts from family. In many systems, receiving a gift is not income for the person receiving it. Some countries tax large gifts or inheritances separately, sometimes charging the giver or the estate rather than the receiver.
• Moving your own money around, such as transfers from your savings to your current account.
• Selling personal belongings at a loss, such as an old bike sold for less than you paid. Selling items regularly for profit can be different: it may count as trading.
• Repayments, such as a friend paying you back for concert tickets.

Leo had two of these last year. His grandparents gave him $500 for his birthday, and he sold an old camera for $200, less than he paid. Under the illustrative system, as in many real ones, neither goes on his return.

Profit, not takings

Self-employment income needs special care, because what you report is usually profit, not the total your clients paid you. Leo's clients paid $8,000, but he spent $2,000 on things he needed for the work, such as design software and a drawing tablet. His self-employment income for the return is $6,000. Lesson 7 looks closely at which expenses count; for now, the important point is that revenue and profit are different numbers.

Why the type matters

If all income ends up in one total, why sort it at all? Three reasons:

1. Different rates or reliefs. Many systems tax dividends or capital gains at different rates from wages, or give a tax-free amount for one type only.
2. Different collection. Employment income usually has tax taken at source. Self-employment and most investment income often do not, which affects how much you still owe.
3. Different checks. Tax authorities often receive reports from employers and banks, and compare them with your return. A mismatch can trigger questions.

Leo's total income

Leo puts each item in its category. In the illustrative system, interest is fully taxable with no special allowance, which keeps the arithmetic simple.

His $1,500 pension payment is not income at all; it is money he paid out. It will matter in the next lesson, where it helps reduce the part of his income that is taxed. Leo writes $48,300 at the top of his worksheet and labels it "total income".

Recap

• Income comes in types: employment, self-employment, investment, capital gains, rental and other.
• Different types can be taxed, collected and checked differently, even though they share one return.
• Some money received, such as most family gifts and repayments, is usually not income.
• For self-employment, you report profit after allowable expenses, not the total received.
• Leo's total income under the illustrative system is $48,300.