Uncle Sam's Revenge

Who: This post is for those of you who have no idea how the income tax works or is assessed. You will find this post helpful if you want a general idea of how your taxes work and if you want a conceptual idea of how to file a tax return.
What: This post will give an overview of how the income tax works and how it is assessed. The concepts of deductions, credits, withholdings, and exemptions will be discussed.

Disclaimer: I am not a tax accountant or specialist. There may be specific scenarios or extenuating circumstances that render the information presented here as not precisely or “technically” accurate, so please proceed with caution. This is intended as in introduction to what income taxes are and how they work. It is geared towards novices and those who are just getting ready to prepare their own (simple) tax returns.

Federal and state income taxes are pay as you go taxes. I am sure many of you have noticed FICA, Medicare, Federal Income Tax, and State Income tax eating into your paychecks. These are taxes that are withheld from every paycheck. Theoretically, at the end of the year your federal and state income taxes owed to the government should equal the total amount that has been withheld over the course of the year. That means your tax return is $0 and that you owe the government $0 at tax time. However, for a variety of reasons (some of which I’ll be covering here) it is exceedingly rare that the amount you pay exactly equals the amount you owe.

In this, the first of a series of posts about income taxes, I’ll cover the very basic case of how income taxes are calculated. In future posts, I’ll be discussing things like withholdings, FICA, Medicare, and AMT (If I ever figure that out). So let’s go through the steps to figure out how your taxes are calculated. If you have an income tax return from a recent year in front of you it may be easier to follow along.

Steps For Tax Calculation

Step 1: Figure out your income. This includes wages, interest earned on savings (bank interest, etc), and a variety of other items. For tax purposes, you’ll want to make sure you cover everything so you accurately represent your income. The total here is your total income.

Step 2: Calculate adjustments to income. These items include (but are not limited to) contributions to a Traditional IRA (don’t worry if you don’t know that that is), student loan interest paid, or moving expenses. Basically, there is a list of expenses which you can add up, to deduct from your income. When you add up the eligible expenses and then subtract the sum from your total income, you arrive at your adjusted gross income (AGI). You will hear this number mentioned quite often (here and in the real tax world), so remember it.

Step 3: Calculate deductions. The next step is to calculate other deductions to your income. Here you have two choices. You can either take a standard deduction, which is just a standard amount specified by the government every tax year. For example, in 2006, the standard deduction for a single filer is $5,150. This means that you would be allowed to subtract $5,150 from your AGI. The other, more complicated option is to itemize deductions. When you itemize your deductions, you are deciding NOT to use the standard deduction because you have other deductions (there is a list of these too, and they include things like donations to charity, interest paid on a mortgage, etc). If your itemized deductions sum to a higher number than your standard deduction, it is in your best interest to itemize and subtract a larger number from your AGI. So for the purposes of this intermediary step, let’s call the standard deduction or the sum of your itemized deductions your simple deductions.

Step 4: Now, we need to take into account something called an exemption. Exemptions are a way of compensating a taxpayer for costs of children or other dependents. Exemptions are somewhat simple to calculate. Each taxpayer receives a personal exemption for themselves and then one for each dependent that they have. So if when I file my tax return, I may want to claim 3 exemptions, one for myself, one for little Jill Wallets and one for little Baby Wallets. Once I know how many exemptions I have, I can calculate the deduction I receive for these exemptions. If for example, in a given tax year, the government allows $3000 for each personal deduction, I know that I can deduct an additional $9,000 from my taxes (3 exemptions * $3,000 each). Now, we can call this quantity the exemption deduction.

Step 5: This is a simple step. We add up the simple deduction and the exemption deduction to get the total deduction. From your AGI, you subtract your total deduction to arrive at your taxable income.

Step 6: Calculate the taxes you owe. Based on your taxable income, you can figure out how much tax you owe by using the federal tax brackets. For an explanation of how tax brackets work, take a look at this neat little calculator from MoneyChimp and read my post on Tax Brackets. The basic principle is that moving to the next tax bracket doesn’t mean that your entire income is taxed at a higher bracket, only the amount above and beyond the already taxed amount. For example, in 2006 for a Single filer, dollars 0 through 7,550 are taxed at 10 percent, and dollars 7,551 - 30,650 are taxed at 15%. So if your taxable income is $30,000, it is not all taxed at 15%. You are taxed at 10% for your first 7550 dollars ($750) and at 15% on the rest ($30,000 - $7,550 = $22,450) which is another $3367.50. That is a total of $4117.50 in taxes on taxable income of $30,000. Mr. Wallets realizes that this was a very brief explanation, but he (me) encourages you to play around with the MoneyChimp calculator to get a more intuitive sense of what is happening. This calculation will yield the tax owed.

Step 7: Finally, we calculate credits which decrease the amount we owe in taxes dollar for dollar. There are various credits for child care, education etc. Once you have found all the credits you are eligible for and add them up, you have your total credits. Once you subtract your total credits from your tax owed, you come to your total tax owed.

Step 8: Now, remember that throughout the course of the year you have had taxes withheld. You will receive forms (W-2) at the end of the year that will tell you the total amount of money that you had withheld for federal taxes. This is total amount of taxes withheld. If your taxes withheld are greater than your total tax owed, then the difference is your tax return. If the total taxes owed is greater than taxes withheld, you owe the IRS the difference.

And that, my friends, is the over-simplified, watered down, very general overview of how you pay your taxes. Stay tuned for posts highlighting the simple approach to many other tax concepts. Are there any other tax concepts that you’d like covered by A Financial Revolution?

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