‘Why is my income less than the figure on my employment letter?’ Perhaps you asked this question when you got your first paycheck. Many people are left wondering when they received their first paycheck.
The reason for the difference is simple – income taxes. Benjamin Franklin once said that only two things are certain in this life: death and taxes.
Though income taxes are inevitable, filing for taxes is still a drudgery experience for many. The 15th of April is a dreaded day in most calendars.
However, for something that certain, it is proper to gain a clearer understanding of how it works.
For this quarter, we will consider different topics about taxes. The aim is to help the average person understand how the tax system works and how it affects their finance.
To begin with, this article introduces the concept of income taxes.
Income Subject to Income Taxes
Income taxes are taxes the government charges on your income. For tax purposes, there are two types of income – earned income and unearned.
Earned income is income from employment, business activities, and work. They include income sources like wages and salaries, unemployment benefits, sick pay, and fringe benefits.
On the other hand, unearned income is income from investments, passive income sources, and income sources unrelated to employment. They include interest, dividends, profits on investments, alimony, and interest from savings accounts.
Federal Income Tax and State Income Tax
Earned and unearned income are taxable at federal, state, and local levels.
At the state level, states like Alaska, Florida, Texas, South Dakota, Wyoming, Washington, and Nevada do not receive tax on income while New Hampshire and Tennessee only tax income from interest and dividend.
Progressive Income Tax Rate and Flat Income Tax Rate
Federal tax uses a progressive tax system where people with higher incomes are subject to a higher tax percentage.
Many states use the progressive tax system while other states (Colorado, Illinois, Indiana, Utah, Kentucky, Michigan, North Carolina, Massachusetts, and Pennsylvania) use a flat income tax rate. The flat income tax system uses the same tax rate for everyone irrespective of income.
Tax deductions reduce taxable income (the amount of your income subject to taxation). There are deductions for charitable donations, healthcare expenses, property taxes, mortgage interest, sales tax on personal property purchases, home office, and other job-related expenses. Also, businesses can deduct business expenses like travel, transport, and networking.
Contributions to retirement accounts are also tax-deductible. Taxes are payable on contribution to retirement accounts at withdrawal.
If Mr. A earned $10,000 in 2019, donated $500 to a charity, and spent $200 on mortgage interest, he will pay tax on $9,300 rather than $10,000.
There are two types of deductions: standard deductions and itemized deductions. Standard deductions as at 2020 are:
- Single filing: $12,400
- Head of Household: $18,650
- Joint filing: $24,800
A taxable person can choose the standard deduction or opt for itemized deductions. The latter allows you to highlight and compile all your taxable deductions (as listed above) rather than accept the standard deductions.
While tax deductions reduce the taxable income, tax credits reduce the tax liability. Mr. A’s tax liability at $9,300 taxable income is $1,006. If he has a tax credit of $200, he will pay $806 as tax. There are three types of tax credits:
- Refundable tax credits: If a refundable tax credit is not exhausted after reducing your tax liability to $0, you can get a tax refund. Suppose Mr. A’s tax credit is $1,200 when his taxable income is $1,006. If the tax credit is refundable, he will get a refund of $194.
Examples of refundable tax credits include earned income tax credit and premium tax credit.
- Non-refundable tax credits: With non-refundable tax credits, you cannot get a tax refund even if your tax credit is not exhausted. The highest tax credit you can claim is that which reduces your tax liability to $0.
Examples of non-refundable tax credits include child and development care credit, adoption, mortgage interest credit.
- Partially refundable tax credits: For this category, you can get a refund for a portion of the tax credit that is not exhausted after reducing your tax liability to $0.
Examples of partially refundable tax credits include child tax credit and American opportunity tax credit. For the latter, you can get the lesser of 40% of the remaining tax credit or $1,000.
The Income Tax Bracket
As said before, federal tax is a progressive tax. The government uses a tax table to determine your tax liability.
To calculate your tax liability, you begin at the base of the table (10%). For single filers, the first $9,875 of your income is subject to 10%.
Let us take the example of Mr. B, a single filer, who earns $90,000.
For the first $9,875, Mr. B will pay $987.5 (10% of $9875). For every amount above $9875 and less than $40,125, Mr. B will be subject to a 12% tax rate. Consequently, for the next level, Mr. B will pay $3,630 (12% * [$40,125 – $9,875]). For every amount above $40,125 and less than $85,525, he will be subject to a 22% tax rate. Consequently, for the next level, Mr. B will pay $9,988 (22% * [$85,525-$40,125]).
For every amount above $85,525 and less than $163,300, Mr. B will be subject to a 24% tax rate. Consequently, Mr. B will pay $1,074 (24% * [$90,000-$85,525]).
Mr. B’s total tax liability equals $15, 679.5 ($987.5 + $3,630 + $9,988 + $1,074). The effective (real) tax rate on the $90,000 income is 17.42% ($15, 679.5 / $90,000).
After calculating your tax liability, you can deduct your tax credit to know the actual tax you will pay to the government.
Understanding some crucial concepts relating to income taxes is a positive step to understanding how taxation works and how it affects your finances.
Stay tuned for the next article as we continue to explore essential topics in personal income taxation in more detail.
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