How Do Federal Income Taxes Work? (Part 1 of 3)

Confused about taxesLike most people I know, I was never taught the basics of personal income taxes. But over the years, I’ve developed a simplified understanding of taxes. As a disclaimer, I’m far from a tax expert. You might be reading this as a far more knowledgeable tax guru. But I’m writing this to someone that has never learned how taxes work. Someone that shows up at the tax preparer’s office every year and just hopes to survive and walk out of there with a check coming their way. Someone that just puts a “2” on their W-4 and lets it ride year after year because they don’t know what it means to adjust that and how it affects their paycheck and their tax return. I hope that my simplified example and terms are helpful for you.

Part 1 – Good News: Only a Portion of your Money Gets Taxed!

The first step is not a difficult concept, but it’s critical. As an individual or a family, you’ve earned a certain about of money in the calendar year. But before you can get into tax tables and credits and determining how much money the federal government says that you owe, you need to figure out what portion of your income that you’re actually getting taxed on.

EXAMPLE Tax Calculationsw-2-wage-and-tax-statement

[Instead of throwing theory and algebra at you, it will be clearer to use an example. In this example, we have a married couple with 2 young children.]

Start with how much you made (wages, dividends, interest, etc.)

Example:

$67,500 total household gross income

Simple enough. It doesn’t matter if you have 1 income source or 10 income sources in your family, just throw it all into bucket to see what your total income is.

In your paycheck you’ll have a variety of items that are deducted from your take home pay. Some of those items are deducted BEFORE your taxes are calculated. The Federal government will not tax you on items such as: health insurance, dental insurance, Health Savings Accounts (HSA). Also, a Traditional 401k retirement plan is federal tax-free until you withdraw it when you retire.

So in our example, throughout the year 2014:

$3500 is withdrawn for Traditional 401k retirement

$5500 is withdrawn for health insurance premiums and HSA

So the government says, really you made $67,500 – $3500 – $5500 =

$58,500 this is your Adjusted Gross Income (AGI); your starting point for taxes

But the government doesn’t tax you on all of that income. They adjust it down further using personal exemptions and deductions. Don’t let the fancy IRS words confuse you. They really just subtract a little more from your income (AGI) before they start calculating how much money you made that they’re going to tax you on.

Personal exemptions are determined by your family size. So a married couple with 2 kids (under 19 or under 24 and full-time student) would have 4 deductions of $3950 per person (2014 value):

$3950 X 4 = $15,800 in personal exemptions

There are 2 options for your deductions. The first option is to itemize. There is a whole list of “tax deductible” items (you often hear people say that you can “write something off”). The most common things for most families would be charitable donations and mortgage interest. (If you give a lot to charity, pay a lot of mortgage interest, or otherwise know that you have a lot of “write off” items, you’ll need to learn a little more about itemizing) For the sake of simplicity, we’ll take the other option, the standard deduction. For a married couple, this a flat amount determined by the IRS each year. In 2014, it will be $12,400. (So you’d have to have donations, mortgage interest, and other tax-deductible items in excess of $12,400 in order to justify adding complication to your taxes and itemizing all of your deductions in order to reduce the amount of taxes you owe.)

Now you have what you need to calculate how much money you have to tell the IRS you made last year that they should tax you for.

$58,500 AGI (Remember, this is not the same as your Gross Income)

–  $15,800 family of 4 exemptions

–  $12,400 standard deduction

= $30,300 Taxable Income

That’s it! You now know what your taxable income is. You made $67,500 but for tax purposes, the federal government says, nah, let’s just worry about $30,300 of that. We’ll tax you on that portion and go from there. The first $37,200 is free!

The next step is to move onto the dreaded “tax tables”!!! Don’t worry, I’ve got you covered in Part 2, it’s not as intimidating as we might make it out to be.

Come back in a couple of days and we’ll work through Part 2 and then a nice summary that will bring it all together!

-Joel

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