Taxes are kind of a beloved hobby of mine. I once entertained the idea of becoming a CPA, and who knows… maybe someday that will happen. For now, I just like reading and learning the different tax laws and how to use them for my benefit!!
I am always a little surprised, when having conversations about taxes, how very few people understand tax withholding. It isn’t something that is common knowledge, even though everyone who earns income, pays taxes! I thought it would be fun to make a few posts on the tax basics for anyone who is interested! I am going to talk about Federal taxes only, but keep in mind these are separate from state income tax.
Tax Filings and Returns, the basics: For ease of explanation, I am going to base these scenarios on a W-2 employee: meaning an individual is hired by a person, business or corporation and receives a regular paycheck with tax withholding.
Here is how the tax filing process works:
(*It may help to take out a copy of your last year’s federal tax return and review it as we go along*)
- Taxes are withheld from your paycheck, and can be seen as a deduction titled “Federal Withholding” or some abbreviation of it. Your employer will automatically withhold a specific percentage from your paycheck, before you ever see it. This percentage depends on how you filled out your W-4 when you were hired, or when you last updated it.
- On December 31, the withholding stops for the current year, and your employer will produce a W-2 form for you. The W-2 is required to be in the mail to you by January 31, and it itemizes all of your income and withholding for the prior year.
- When you have all of your W-2 forms and other tax forms required to file your taxes, it’s time to file! The first step is to calculate all of your income (line 22), less allowable expenses and deductions (line 37). This figure is your Adjusted Gross Income (line 37).
- Your AGI is then reduced by the standard or itemized deductions (line 40) and your exemptions (line 42). This number is your Taxable Income (line 43), on which your total tax is calculated and that amount is what you pay tax on (see brackets below).
- But to make it even more confusing, this tax amount can be reduced by credits (line 54) and increased by other taxes (lines 56-60). This becomes your Total Tax (line 61)
- The next section, Payments, itemizes your annual withholding (line 62) and estimated payments (line 63) and other credits (lines 64-71). This determines your total payments (line 72)
- If your Total Payments (line 72) exceed your Total Tax (line 61), you get a refund (line 73)!
- If your Total Tax (line 61) exceeds your Total Payments (line 72), you will owe more money to the IRS, because there weren’t enough credits and withholding to cover the amount of income tax you owe.
What’s your tax rate: It is a common misconception that individuals pay a flat tax rate, correlating to their income level. This is not the case.
Example: Let’s say John’s total taxable income (line 43) for 2012 is $150,000. Let’s also assume he doesn’t have any credits (line 54) or other taxes (lines 56-59). John is married and filing jointly. John will pay the following taxes, based on the 2012 tax brackets:
- 10% on the first $17,400
- 15% on the next $53,300 ($17,401-$70,700)
- 25% on the next $72,000 ( $70,701-$142,700)
- 28% on the remaining $7,299 ($142,701-$150,000)
John’s total tax will be $29,778.72. If we assumed all of his income was taxed at 28%, then he would owe a total of $42,000, which is wrong. It’s important to note that individuals pay a blended rate, and the majority of John’s income was not taxed at 28%.
Not that difficult, huh? The basics aren’t, but when you get into self-employment, interest income, rental income and expenses, and such, it gets progressively more involved.
Once you know the basics, you can learn how to take advantage of the different deductions! Check out my post on My Favorite Tax Deductions to see if there is anything you qualify for, that you’re not claiming!
**I am not a CPA, and cannot legally give tax advice. I am simply sharing what I have learned from classes and personal experience over the years. If you have specific tax questions, please visit a CPA.**
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