Understanding how income taxes work

Elizabeth Rosen
by Elizabeth Rosen, Contributor

 

For most people, the thought of paying income taxes makes their spine tingle. While everyone knows that income taxes are paid to the IRS (Internal Revenue Service) each year, the process of taxation itself can be confusing to many. There are various factors that affect how your personal income is taxed, as well as how much you end up paying to the government or receiving back as a tax refund.

The United States government needs a lot of money in order to function and fund its numerous foreign and domestic programs. Americans are becoming more and more aware of how their tax dollars are spent, but many are still intimidated by the complexities of the taxation process. In a nutshell, individuals are expected to report their yearly income and pay taxes accordingly.

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The money collected from income taxes goes towards federal education programs, the U.S. military, welfare programs, and various agencies (such as the EPA and FDA). Both individuals and companies are required to remit a portion of their income to the federal government on an annual basis. If/when politicians decide that more money is needed for certain programs, they often raise income taxes to pay for them.

While legislators construct and implement tax laws, the IRS is the federal agency in charge of enforcing those tax laws and collecting the taxes. The IRS also provides assistance to taxpayers who have questions, concerns, or issues with their tax situation. Due to advancements in technology, many tax preparation and filing services are available online.

Income Tax Brackets & Tax Rates

The amount of income tax that you owe each year is based on your income level. The United States currently uses a progressive income tax system — which means that the more money you earn, the more taxes you have to pay. Fortunately, there are ways you can reduce your income tax liability by using various tax credits, tax deductions, tax exclusions, and other tax breaks.

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The majority of individuals are subject to the “Pay-As-You-Go” system, which means that their income tax is deducted from each paycheck and sent to the IRS. This is also referred to as withholding tax. If you are self-employed, the IRS expects you to pay income tax on a quarterly basis (typically in equal installments every 3 months).

At the end of the year, if your payments were not enough to cover the total income tax due, you must pay the rest to the IRS. Conversely, if you paid too much over the course of the year (more than what you owe in income tax), the IRS will send back your excess payment in the form of a tax refund.

Your marginal tax bracket is the highest tax rate that you will pay on your income. For tax year 2013, there are 7 marginal income tax brackets for each filing status: 10 %, 15 %, 25 %, 28 %, 33 %, 35 %, and 39.6%

The marginal tax bracket system is a gradual tax schedule, which basically translates to this: as you make more money, you pay more tax. The amount of taxable income that you earn determines which tax bracket(s) you fall into. While it is the goal of many taxpayers to keep their income in the lower tax bracket, remember that the gradual tax schedule ensures that not all of your income is taxed at a higher rate.

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For example, if you move from the 25% tax bracket to the 28% tax bracket, you may think that all of your income is taxed at that higher rate. However, only the money that you earn within the 28% bracket is taxed at that rate.

Income Tax Returns

There are several different types of individual income tax return forms issued by the IRS. You must use the tax form that corresponds with your particular situation and allows you to claim the income, deductions, credits, etc. that apply to you.

The most common types of income tax returns include the following:

  • Form 1040 (U.S. Individual Income Tax Return) (a.k.a. “the long form)
  • Form 1040A (U.S. Individual Income Tax Return) (a.k.a. “the short form)
  • Form 1040EZ (Income Tax Return for Single and Joint Filers With No Dependents)
  • Form 1040NR (U.S. Nonresident Alien Income Tax Return)
  • Form 1040NR-EZ (U.S. Income Tax Return for Certain Nonresident Aliens With No Dependents)

Most U.S. citizens will need to file a federal income tax return every year and determine how much they owe in federal income tax. While the majority of people are required to file and pay income taxes, there are certain low-income earners (as well as children) who are exempt. You will most likely have to file an income tax return, but you should check the IRS’s filing requirements before you proceed.

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Most people can simply review their W-2s (Wage and Tax Statements) to determine their annual income, although this can get slightly more complicated if you have worked more than one job during the year.

State Income Taxes

State income taxes are separate from the federal tax laws enforced by the IRS. State taxes are levied by each individual state government ― there is no system that encompasses the separate taxes for all 50 states. For this reason, state taxes will vary (sometimes greatly) based on where you live, shop, invest, work, and conduct business. State taxes may be administered by a department of revenue, department of taxation, state treasurer, or state comptroller.