Income taxes are so confusing. How do they work?
In my last blog, we talked about whether or not a person should attempt to do his or her own taxes. Part of the decision-making process is whether or not you enjoy reading complicated rules and regulations.
Even if you answered “no” to that question, and decided to have someone else prepare your taxes this year, I think it’s still wise for anyone to understand the basics of how their income taxes work.
Determining taxable income
First, it’s important to realize that, with a few exceptions, all income is taxable. Why? Because the IRS says so. The federal government decides what income is taxable and what isn’t. In most cases, I would say expect the income you receive to be taxable. My favorite saying is this: The IRS giveth and the IRS taketh away. But, considering it’s taxes, the math gets much more complicated than that!
Now that we have that understanding in place, let’s start with your gross income. Gross income includes all of the money you received during the year. For most people, it is simply the amount you would say if someone asked you how much you make or if a company made you a job offer.
Next, you deduct what is known as above the line deductions. Some examples of above the line deductions include educator expenses, student loan interest, shareholder health insurance, etc. The remaining amount after these deductions is your Adjusted Gross Income or AGI.
Once you arrive at your AGI, you have a choice. You can deduct either the standard deduction or your itemized deductions. The standard deduction is an amount of income that is not subject to tax. You basically get that amount of income tax-free. The amount varies with your filing status (single, married filing jointly, etc.).
Itemized deductions include such things as mortgage interest and charitable contributions. The trick here is this: you want to deduct whichever amount is greater. If your itemized deductions are bigger than the standard deduction, then you use that amount (called itemizing). If your itemized deductions are less than the standard deduction, then you just deduct the standard amount.
Now that we have all the deductions taken care of, we have arrived at your taxable income. To calculate how much tax you should have paid for a given year, you multiply your taxable income by the tax rate as determined by your filing status.
Paying your income taxes
The amount of income tax you should have paid in is generally paid in one of three ways. The most common form of payment happens throughout the year through taxes withheld from your paycheck. This is known as your withholding and the amount that was withheld will be shown on your W-2.
Another form of prepayment is through estimated tax payments. This is a common form of tax payment for self-employed or 1099 workers. Estimated payments are generally paid quarterly.
Another form of “payment” are tax credits, such as the Earned Income Credit or Child Tax Credit. These reduce your tax liability dollar for dollar.
Now, what if you still owe money after your withholding, payments and credits? You have until the tax deadline each year on April 15 to file your taxes and pay the remaining amount. You can send a check via mail or the IRS has a website where you can pay any balance due.
What if I get a refund?
If you have paid in more than you should have, the IRS will refund you the excess. I want to debunk a common misconception about tax refunds. Too many people think the government is paying them money every year with the tax refund. That’s not true! Your tax refund is getting your own money back because you paid more than you owed.
Think of it like this: Let's say you were going to see a movie but didn't know how much tickets cost. So you just made an educated guess and made an online payment for $15. But when you got to the movie theater, the ticket was only $12. You'd get that $3 back. That's what your tax refund is. It's a refund of money you ended up not owing.
Even though I don't prepare taxes, my clients often have questions about how much their withholdings should be or how much they should pay in estimated taxes. If you are struggling to find the right mix for your situation, give me a call and let me help.