It is mandatory that all Americans pay their income taxes each year. It is a lengthy process that can be explained in a few steps.
- Determining Taxable Income: Taxable income is the net income after deductions that income tax is computed. Not all income is taxed. Your total income (gross income), can include the following:
- Earned Income: Usually wages, salaries, commission, tips, and bonuses
- Investment Income: Money in the form of dividends, interest, or rent from real estate investments. It is also referred to as portfolio income
- Passive Income: This is money that is earned by not actively participating in business activities, such as a limited partnership
Other income such as lottery winnings, alimony, and prize money won on game shows are also taxable income.
Gross income is also affected by exclusions (known as tax-exempt income), and tax-deferred income. Exclusions are income that is not taxed, and tax-deferred income is income taxed at a later date.
When reductions are made, gross income becomes adjusted gross income. An example of a reduction is medical expenses. Adjusted gross income is used to calculate income tax deductions.
Some adjustments are a kind of tax shelter, which are investments that provide tax benefits and an expectation of a financial return in the future.
2. Computing Taxable Income: Tax deductions are now taken into account. Tax deductions are subtracted from the adjusted gross income to reach taxable income. A standard deduction is at least what every taxpayer receives, and is an amount on which no taxes are paid. However, some people qualify for more than just the standard deduction. They also qualify for itemized deductions, which are expenses you are allowed to deduct from the adjusted gross income. Itemized deductions can include:
- Medical and dental – fees, prescriptions, hospital expenses, premiums, or medical travel that has been paid by you
- Taxes – this includes any state, local, or real estate property tax
- Donations – anything that has been donated to a qualified charity organization
- Interest – interest from mortgages, home equity loans, and investments
- Casualty – financial loss caused by natural disasters
- Job-related expenses – job travel, required education, work clothing, or anything work related that was not reimbursed
Another kind of deduction that can be subtracted from the adjusted gross income is an exemption, which is a deduction from your adjusted gross income for yourself, your spouse, and qualified dependents.
Note: A person can qualify as a dependent if they are related to you, are under 19, or under 24 if a full-time student, live with you for more than half the year, and be financially supported by you. They may have a job, but it should not provide more than half of financial support.
3. Computing Taxes Owed: This is where taxable income comes into play. It is needed to determine the amount of taxes owed, along with the appropriate rate on taxable income. An example of a tax table is below.
Each tax rate represents an income level, known as a bracket.
The first 7 (10% to 39.6%) percent rates are known as marginal tax rates, which are rates that are used to calculate tax on the last dollar of taxable income. However, the average tax rate is based on total tax due divided by taxable income. This rate is lower than someone’s marginal tax rate, excluding taxpayers in the 10% tax bracket.
The taxes owed can be reduced with a tax credit, which is an amount subtracted from the taxes owed. Examples of a tax credit include The Child and Dependent Care Credit, and The Retirement Savings Contributions Credit. This is not to be confused with a deduction. A tax credit directly reduces the amount of taxes owed, while a deduction depends on the taxpayers’ marginal tax rate.
- Paying Taxes: Payments are made either through withholding payroll or estimated tax payments.
- Payroll: The pay-as-you-go system requires employers to deduct federal income taxes from wages. The amount that is withheld depends on the number of exemptions and deductions claimed. So, the amount withheld from a person who is married with children would be less than that of a single person with the same pay, since the married person owes less tax. At the end of the year, you will receive a W-2 form that is a breakdown of annual earnings and amounts deducted for taxes. The difference between the withheld amount and the amount of taxes owed can either be your refund, or what you need to pay.
Note: Students and low-income individuals can file for an exemption from withholding if they have not paid federal income tax the previous year and do not plan on doing so in the current year.
- Estimated tax payments: People who receive income from savings, investments, pension payments, and royalties are required to make tax payments during the year. The payments are based on an estimate of taxes due at the end of the year.
- Meeting the Deadline: It is required that a federal income tax return must be filed by April 15th. If in an event that you cannot, you can always acquire a six-month extension using Form 4868. This pertains to 1040 forms and others but does not delay your obligation to pay. It is mandatory that you submit form 4868 with the estimated amount owed by April 15th to avoid a penalty. Failure to pay the full amount owed can result in interest charges on the amount you should have paid.
Note: If you claim a refund several months/years late, but within three years of filing or within two years of paying the tax, the IRS will pay you interest.
Filing your federal income taxes seems like a prolonged development, but it is beneficial to know what goes on throughout the process.