6.13 Income Tax
3 min read•june 18, 2024
Income tax is a complex system that affects everyone's finances. It's based on your total earnings, with deductions and credits reducing what you owe. Understanding the basics helps you make informed financial decisions and plan for tax season.
The U.S. uses a system, meaning higher earners pay a larger percentage. Knowing how to calculate your and apply credits can potentially save you money. It's crucial to stay updated on tax laws and filing requirements.
Income Tax Fundamentals
Components of taxable income
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- encompasses all income from various sources such as wages, salaries, tips, interest, dividends, alimony received, business income, rental income, and
- Non-taxable items like gifts, inheritances, and certain benefits are excluded from
- (AGI) is calculated by subtracting adjustments (educator expenses, student loan interest, alimony paid) from gross income and serves as the basis for determining many tax benefits and limitations
- Taxable income is calculated by subtracting deductions and from AGI
- Deductions can be either the , a fixed amount based on filing status, or (mortgage interest, state and local taxes, charitable contributions)
- are suspended for tax years 2018-2025 due to the
Calculation of income tax
- The U.S. has a progressive tax system with increasing tax rates for higher income levels, and tax brackets are adjusted annually for inflation
- applies to income within each bracket
- Income tax owed is calculated by:
- Multiplying taxable income within each bracket by the corresponding tax rate
- Summing the results to determine total income tax owed
- directly reduce the amount of tax owed, dollar-for-dollar, with examples including the (EITC), , and education credits
- Some credits are refundable, meaning they can reduce tax owed below zero, resulting in a refund
Tax Reporting and Payments
- is deducted from an employee's paycheck to cover their estimated income
- Taxpayers file a annually to report their income, deductions, and credits
- A is issued when the amount of taxes paid through withholding or estimated payments exceeds the actual tax liability
- Tax credits reduce the amount of tax owed directly, while tax deductions reduce taxable income
Payroll Taxes
FICA tax computation
- (Federal Insurance Contributions Act) taxes consist of Social Security and Medicare taxes, which are a shared responsibility between employees and employers
- :
- Employee contribution is 6.2% of gross wages up to the ($160,200 for 2023)
- Employer matches the employee contribution
- :
- Employee contribution is 1.45% of all gross wages with no wage base limit
- Employer matches the employee contribution
- Additional Medicare tax of 0.9% is applied on wages above 250,000 (married filing jointly) and is paid solely by the employee
- Self-employed individuals are responsible for both the employee and employer portions of FICA taxes (12.4% for Social Security and 2.9% for Medicare) but can deduct half of as an adjustment to income
Key Terms to Review (34)
Adjusted gross income: Adjusted Gross Income (AGI) is an individual's total gross income minus specific deductions, known as adjustments. It is used to determine taxable income and eligibility for certain tax credits and deductions.
Adjusted Gross Income: Adjusted Gross Income (AGI) is a measure of income that is calculated from gross income and used to determine how much of your income is taxable. It reflects total income after specific adjustments, such as retirement plan contributions, student loan interest, and alimony payments, which can lower the overall taxable income. AGI is crucial in the context of income tax as it serves as the starting point for calculating taxable income and determining eligibility for various tax credits and deductions.
Capital gains: Capital gains are the profits earned from the sale of an asset, such as stocks, real estate, or other investments, that has increased in value since it was purchased. These gains are essential in understanding personal finance and investment strategies, as they directly influence an individual’s taxable income. The taxation of capital gains can vary based on how long the asset was held before selling, impacting financial decision-making for investors.
Child Tax Credit: The Child Tax Credit is a tax benefit offered to families with dependent children to reduce their tax liability. This credit provides financial assistance to help families afford the costs associated with raising children, thereby encouraging family support and reducing poverty among children. It can be claimed on annual income tax returns, making it an essential tool for families to alleviate some of their financial burdens.
Earned income: Earned income is the money that individuals receive as a direct result of their work or services, including wages, salaries, bonuses, and tips. This type of income is subject to taxation and plays a crucial role in determining an individual's tax obligations. Understanding earned income helps individuals manage their finances, plan for taxes, and maximize potential deductions.
Earned income credit: The earned income credit (EIC) is a tax benefit designed to assist low to moderate-income working individuals and families by reducing their tax liability and potentially providing a refund. It aims to encourage employment by offering financial support based on earned income and the number of qualifying children. The credit is refundable, meaning if it exceeds the tax owed, the taxpayer can receive the difference as a refund.
Earned Income Tax Credit: The Earned Income Tax Credit (EITC) is a federal tax credit designed to assist low- to moderate-income working individuals and families, particularly those with children. This credit not only helps reduce the amount of tax owed but also may result in a refund, effectively boosting the income of eligible taxpayers. It serves as an incentive for work and aims to alleviate poverty by encouraging employment while providing financial support to those who qualify.
Effective tax rate: The effective tax rate is the average rate at which an individual or corporation is taxed on their income, calculated by dividing the total tax paid by the total taxable income. This rate provides a more accurate picture of a taxpayer's burden than marginal tax rates, as it reflects all forms of taxation, including deductions and credits. Understanding the effective tax rate helps individuals and businesses assess their tax liabilities and make informed financial decisions.
Exemptions: Exemptions are specific amounts that taxpayers can subtract from their gross income to reduce their taxable income. They can be claimed for the taxpayer, their spouse, and dependents.
FICA: FICA, or the Federal Insurance Contributions Act, is a U.S. law that mandates a payroll tax to fund Social Security and Medicare programs. This tax is automatically deducted from employees' paychecks and is essential for providing benefits like retirement income and healthcare for seniors. Understanding FICA is crucial because it directly impacts individuals' net pay and contributes to vital government services that support the aging population.
Form 1040: Form 1040 is the standard Internal Revenue Service (IRS) form used by individual taxpayers to file their annual income tax returns in the United States. This form allows taxpayers to report their income, claim deductions and credits, and calculate their tax liability or refund for the year. It's essential for ensuring compliance with federal tax laws and is a key document in the process of income tax filing.
Gross income: Gross income is the total income earned by an individual before any deductions or taxes are applied. It includes wages, salaries, bonuses, and other forms of earnings.
Gross Income: Gross income is the total income earned by an individual or entity before any deductions, taxes, or other expenses are taken into account. This includes wages, salaries, bonuses, rental income, investment earnings, and any other sources of income. Understanding gross income is essential for creating effective personal budgets and for calculating tax liabilities.
Internal Revenue Service: The Internal Revenue Service (IRS) is the U.S. government agency responsible for administering and enforcing federal tax laws. It plays a crucial role in collecting taxes, processing tax returns, and ensuring compliance with tax regulations, which are fundamental aspects of the overall income tax system in the United States.
Itemized deductions: Itemized deductions are specific expenses that individuals can deduct from their taxable income to reduce the amount of tax owed. This option allows taxpayers to list and subtract various eligible expenses, such as medical costs, mortgage interest, and charitable contributions, instead of taking the standard deduction. By choosing itemized deductions, individuals may be able to lower their tax liability more effectively than relying on the flat-rate standard deduction.
Marginal Tax Rate: The marginal tax rate is the percentage of tax applied to an individual's or entity's last dollar of income. It plays a crucial role in understanding how tax systems are structured, especially in progressive tax systems where rates increase with income levels. As income increases, the marginal tax rate determines how much additional tax a person pays on each additional dollar earned, influencing financial decisions and economic behavior.
Medicare tax: Medicare tax is a federal payroll tax that funds the Medicare program, which provides health insurance for individuals aged 65 and older, as well as certain younger people with disabilities. This tax is deducted from employees' wages and is matched by employers, contributing to the overall financing of healthcare services under Medicare. Understanding Medicare tax is essential for grasping how income taxes and payroll taxes function within the broader taxation system.
Personal exemptions: Personal exemptions are specific amounts that taxpayers can deduct from their total income to reduce their taxable income, typically granted for the taxpayer and their dependents. This deduction allows individuals to lower their taxable income based on the number of people they support financially. Personal exemptions have historically played a significant role in tax calculations, impacting the overall amount of taxes owed and the effective tax rate.
Progressive tax: A progressive tax is a tax system in which the tax rate increases as the taxable amount increases, meaning that higher income earners pay a larger percentage of their income in taxes compared to lower income earners. This system is designed to reduce income inequality by imposing a heavier tax burden on those who can afford to contribute more, while providing relief to those with lower incomes.
Schedule A: Schedule A is a form used by taxpayers in the United States to itemize deductions when filing their federal income tax returns. By using Schedule A, taxpayers can list eligible expenses such as medical costs, state and local taxes, mortgage interest, and charitable contributions, potentially reducing their overall taxable income. This process allows individuals to maximize their tax benefits by taking advantage of deductions that may exceed the standard deduction.
Self-Employment Taxes: Self-employment taxes are taxes that individuals who work for themselves must pay to cover Social Security and Medicare. Unlike employees, self-employed individuals do not have an employer to withhold these taxes from their paychecks, so they must calculate and pay them directly. This tax is crucial for ensuring that self-employed people contribute to their future social security benefits and Medicare coverage.
Social Security tax: The Social Security tax is a payroll tax imposed on both employees and employers to fund the Social Security program, which provides benefits for retirees, disabled individuals, and survivors of deceased workers. This tax is essential for maintaining the financial stability of the program, ensuring that individuals can receive income support during retirement or in times of disability. The Social Security tax is part of the larger framework of income taxes and contributes to the overall taxation system used to fund various government programs.
Social Security wage base: The Social Security wage base is the maximum amount of an individual's earnings that are subject to Social Security tax in a given year. This limit is set annually and determines the income level at which Social Security taxes are applied, impacting how much individuals contribute to their future benefits. Understanding the wage base is essential for grasping how Social Security financing works and the implications it has on income tax calculations.
Standard deduction: The standard deduction is a fixed dollar amount that reduces the income on which an individual is taxed, effectively lowering their taxable income. It simplifies the tax filing process by allowing taxpayers to deduct this amount without needing to itemize deductions, making it easier for many to file their taxes. The standard deduction amount varies based on factors such as filing status, age, and whether the taxpayer is blind.
Tax bracket: A tax bracket is a range of income that is taxed at a specific rate, which increases as income rises. Understanding tax brackets is essential for determining how much of an individual's income is subject to different rates of taxation, often influencing financial decisions and tax planning strategies.
Tax credit: A tax credit is an amount of money that taxpayers can subtract directly from the taxes they owe to the government, effectively reducing their tax liability. Unlike tax deductions, which lower taxable income, tax credits reduce the actual tax bill, making them a valuable tool for taxpayers looking to minimize their tax burden. They can be available for various reasons, such as supporting specific social policies or encouraging certain behaviors.
Tax credits: Tax credits are amounts subtracted directly from the tax owed, reducing the overall tax liability. They can be either refundable or non-refundable.
Tax Cuts and Jobs Act: The Tax Cuts and Jobs Act (TCJA) is a significant piece of legislation enacted in December 2017 that made substantial changes to the U.S. tax code, primarily aimed at reducing individual and corporate tax rates. This act introduced a range of modifications, including an increase in the standard deduction, changes to itemized deductions, and a reduction in corporate tax rates from 35% to 21%, aiming to stimulate economic growth and increase job creation.
Tax deduction: A tax deduction is an expense that you can deduct from your taxable income to reduce the amount of tax you owe. This financial tool helps individuals and businesses lower their overall tax liability by allowing them to subtract specific expenses, such as mortgage interest, medical expenses, or charitable contributions, from their gross income. By decreasing taxable income, tax deductions can lead to significant savings on tax bills.
Tax liability: Tax liability is the total amount of tax owed to the government based on taxable income and applicable tax rates. This concept is crucial when understanding how different types of income, deductions, and credits affect what an individual or entity ultimately owes in taxes, influencing financial decisions related to property ownership and rental agreements.
Tax refund: A tax refund is a reimbursement from the government to a taxpayer when their tax payments exceed their tax liability for the year. This occurs when individuals or businesses have withheld more money from their income than is necessary, or when they qualify for certain deductions and credits that lower their overall tax bill. The refund serves as a way to return the excess amount, and it can be viewed as an interest-free loan to the government during the tax year.
Tax return: A tax return is a formal document filed with a government authority that reports income, expenses, and other pertinent tax information for a specific period, usually a year. This document is essential for individuals and businesses to calculate their tax liability, determine eligibility for certain credits or deductions, and ensure compliance with tax laws. Completing a tax return accurately can affect the amount of tax owed or the refund received.
Taxable income: Taxable income refers to the portion of an individual’s or business's income that is subject to taxation by the government. This includes wages, salaries, bonuses, and any other income that is not specifically exempted by tax law. Understanding taxable income is crucial as it directly impacts the amount of taxes owed and the overall financial planning for both individuals and businesses.
Withholding tax: Withholding tax is a government requirement for employers to withhold a portion of an employee's earnings and remit it directly to the tax authorities as part of the income tax process. This system ensures that income taxes are collected efficiently and timely, preventing taxpayers from having to pay their entire tax bill at once when filing returns. By deducting taxes at the source, withholding tax also helps individuals manage their cash flow throughout the year.