Welcome back to part two of the Understanding Taxes series, where the process of actually paying taxes will be covered today. The American Tax system itself is already complicated enough with its multitude of different types of taxes, but adding on confusing processes of paying taxes and heaps of paperwork can lead to frustration and confusion, often causing issues for those who were unfortunate to not understand the complex tax system. However, this post is here to help explain how to overcome the prospect of paying taxes and to save you from any issues you may encounter in the future.
Federal and State Tax Brackets
Before we begin, an important misconception must be cleared up regarding tax brackets. In America, you pay a different percentage of tax on your income depending on how much you make. The 2021 Federal Tax Brackets for single filers are listed below. More information on tax brackets are available here.
Now, most people think that you only pay one tax percentage based on what you make. For example, a person making $150,000 would fall into the 24% tax bracket and would therefore pay 24% of $150,000 in taxes $36,000, meaning the person would walk away with $114,000, right? Not exactly. You would actually have to pay a 10% tax on any money earned up to $9,950, then a 12% tax on any income from $9,951 to $40,525 dollars, and so on. Using the $150,000 income as an example, the third column shows that you would owe $14,751 dollars in taxes and 24% based on how much you make above $86,375 (in this case, that would be $15,270, meaning you would pay a grand total of $30,021 in federal income taxes on a $150,000 salary). You must fill each “pocket” with money until you run out of money and then each “pocket” of money is taxed at a different rate until all of your money has been taxed. Get it? Good. State tax brackets work similarly but depend based on the state.
The W-4 Form
Before you start paying taxes, there is actually a bit of admin to get through. First of all, you need to have a job with a taxable income, known as your gross income, agreed upon by you and the employer. After this, you fill out a W-4 Form, which can be described as a “miniature tax form,” where it asks for information such as if you are married or single, if you have kids/dependents, and more. These were known as personal allowances but were changed last year and made much easier. In short, personal allowances were essentially exemptions from paying taxes based on certain qualifications you met, such as having a working spouse or having dependents. If you didn’t claim any allowances, the employer could withhold the maximum amount possible from your paycheck. If you didn’t claim enough allowances, then you would have overpaid taxes and could get a refund from the IRS, and if you claimed too many allowances, you would owe the IRS more money (also, quick note, withholding taxes means that the employer would reduce your paycheck and use your salary to pay taxes gradually over the year rather than paying them all at once come tax season).
The revised W-4 Form now offers an easier way to complete this, allowing you to claim dependents and deductions and to list any other sources of income that may qualify you for paying less through the year. It’s important to get these as precise as possible, as the correct amount of claims can lead to larger paychecks and less of a headache when tax season rolls around.
Filing Income Taxes
After filling out the W-4 form and agreeing upon your salary and claiming your deductions, you can now get to filing your taxes in April. To clarify what it is that you will be doing, filing your taxes is done to find out how much you paid in taxes throughout the year. If you fill out your W-4 form precisely, you likely won’t owe or gain anything extra, but more often than not, you will have to go through your payments to see if you either overpaid or underpaid, resulting in either a refund or another payment for you. For individual income tax, you will be required to fill out a 1040 Form. Other tax forms can be found here. The process of filling out the 1040 is listed below.
Calculate your gross income for the year, which can be found on the W-2 Form sent to you by your employer, showing you what you made and how much you paid in taxes over the year.
Calculate any adjustments, such as alimony payments, retirement account deposits, and interest on loans. Subtract adjustments from your gross income to get your adjusted gross income (AGI), also known as your taxable income.
From your AGI, you can choose to subtract either a standard deduction or an itemized deduction, depending on which one brings your total lower (because you want to pay less in taxes, obviously). In 2020, the standard deduction was $12,400 for single filers, meaning that if your AGI was $70,000, you could simply subtract $12,400 as a standard deduction and be down to $57,600 in taxable income for the year, just like that. You can also choose itemized deductions, which may be payments such as charitable donations, medical expenses, mortgage interest, or state/local taxes. If your itemized deductions come out to greater than the standard deduction ($12,400), then the best plan would be to itemize deductions to receive a bigger tax write-off, whereas if your itemized deductions are less than $12,400, it would be wiser to go with the standard deduction.
From here, the plan would be to subtract any personal exemptions, but because of the Tax Cuts and Jobs Act of 2017, the personal exemption was removed for the duration of the act, which ends in 2025.
Taking your taxable income now, you can either manually calculate how much you owe based on the tax brackets, or refer to the IRS Tax Table. For example, the 2020 tax table states that if your taxable income was $60,000 to $60,050, then you would owe $8,996 in taxes, which is known as your gross tax liability. If you’re confused about how they get these numbers, these are derived from the tax brackets. If your taxable income is above $100,000, then you must manually calculate it, but the tax table has a step by step process to guide you through it.
One final deduction can be made on your tax bill through credits. In step 3, the deductions were only a deduction on your taxable income, whereas credit deductions reduce the total you would actually have to pay the IRS. Credits are supplied by the Internal Revenue Code (IRC), such as the Child Tax Credit (which changed due to the American Rescue Plan Act of 2021, read more about the benefits of it here), and the Earned Income Tax Credit. Subtract any credits that qualify, and you’ll be left with your net tax.
Your net tax is what you owe the IRS at the end of the day. If the value is negative, then you can be expecting a check from the government. If your net tax is positive, then you’ve still got some payments to make. Taxes are due by May 17th, 2021, so if you have taxes, pay them. The last thing you want is to get audited by the IRS; that never ends well. With that, part two comes to a close. Come back for part three, where certain tax facts, tricks, and potential loopholes will be discussed.