As part of my journey to try and become more well-rounded, I thought learning a little about finance would be helpful to me in life.
I got my first job ever just 7 months ago (granted, it is an internship), however I have never worked a day in my life so it was both exciting and nerve-wracking to begin. However, along with my job came earning money, and along with earning money came getting taxed.
I now understand why people complain about taxes all the time – what I don’t understand are “taxes” themselves. What are they? Why am I forced to pay them? How are they calculated?
In hopes of learning, I watched this video:
This blog post will be a summary of what I learned; I am mainly writing these as “notes” to myself for future reference, when I will inevitably forget how all of this works because my memory is so poor, so while the knowledge is still fresh in my mind, I thought I would jot it down! If this helps anyone understand taxes, though, I will be very glad.
DISCLAIMER: Most of the knowledge written down here is gleaned from the video I watched, so the only thing I own in terms of creative freedom is just the organization of my notes, everything I write content-wise I have learned from the video. I also do not own the featured image on this blog, so please do not sue me, I barely just got my first job ha ha!
So without further ado, here is a quick and clear explanation of how taxes work.
What are taxes and what purpose do they serve?
Tax collection is the government’s way of raising revenue, as well as encouraging social and economic policy.
So, the raising revenue aspect makes sense (the government uses the money collected from taxes to fund its functions and programs), but how exactly does tax collection help stimulate social and economic policy?
Let’s take an example of how it influences social policy: for instance – contributions. You can earn tax deductions (these are good! More on these in a moment) on your income if you make contributions to a non-profit or some other philanthropic organization; so this social policy is encouraging you to be more charitable with tax deductions as an incentive.
Now let’s view an example of how taxes influence economic policy: for instance – workforce development. You can earn tax credits (these are also good! More on these very soon) on your tax payments if your business hires a certain type or class of worker; so this economic policy is encouraging you to assist in the creation of jobs for specific people with certain skills or backgrounds by using tax credits as an incentive.
What is the IRS and who is required to report to it?
The IRS (Internal Revenue Service) is a federal agency that falls under the United States’ Department of the Treasury. They are the ones in charge of administering and enforcing tax law.
There are five entities that are required to file taxes and that pay directly to the IRS:
- Individuals – ordinary folks like you and me file the 1040 tax return and we pay taxes to the IRS (this comes out of our paychecks)
- Corporations – companies and businesses file the 1120 tax return and they also pay taxes to the IRS (the companies each pay taxes as one entity)
- Partnerships – partnerships (these are small businesses usually managed by 2-4 members who share the partnership’s management and profits) file the 1065 tax return but they do not pay taxes to the IRS as one entity, like the companies do. Instead, partnerships file an “information return” and the members of the partnership each file their own tax returns individually on their share of the income earned. So the partners each pay their own taxes, but the partnership itself is not a tax-paying entity
- Estates – Estates file tax returns
- Trusts – Trusts files tax returns
These lessons will focus on the individual and the tax filing process related to such.
How do we know when we have to pay the IRS (Owing) or when the IRS has to pay us (Refund)?
If you have done taxes before, whether you filed them on your own or if you employed local H&R Block or TurboTax services for help with filing your taxes, then you know that the calculations end up with either of two outcomes: you either owe the IRS money or they need to give you a refund.
As we work, we pay the IRS in the form of a withholding. A withholding is a portion of your income that the IRS deducts from your paycheck and takes as tax payment. The IRS has a “pay-as-you-go” type of system rather than waiting until the end of the year for each individual to pay the amount of taxes that they owe; because of this system, sometimes you pay more than you owe or less than you owe in tax payments to the IRS – hence the reason why sometimes you have to pay the IRS after filing taxes (because it turned out that throughout the year you did not amount to paying the full amount you owe in taxes) or the IRS owes you a refund (on the occasions where throughout the year you ended up overpaying the amount you owe in taxes).
The Tax Formula: How do you determine your taxable income?
We start off with gross income, which is the pure, unadulterated amount of money that you have earned as income from your job, all before taxes are applied. So basically, the gross income is the amount of money you would have made if taxes didn’t exist and you got to keep all of your hard-earned money.
Now, apply tax deductions to this gross income. And this is the part where people get a bit confused – tax deductions are a good thing. The purpose of tax deductions is to decrease your taxable income, and subsequently decrease the amount you owe as payment to the federal government.
For example, let’s go with an absurdly simple example (it is unrealistic but it is just here to prove a point). I made $500 in a year as my gross income, then tax deductions are applied and let’s say the calculations turn out such that $200 of my gross income is taxable income while $300 of my gross income is non-taxable income. Basically, my $300 cannot be touched by taxes, so those $300 are for me to keep; meanwhile, the $200 taxable income CAN be affected by taxes; this does not necessarily mean that I am going to pay $200 in taxes to the IRS, but it DOES mean that my $200 are fair game for taxing, and that a portion of the $200 will be given to the IRS in the form of tax payment.
So, if the purpose of tax deductions is to DECREASE your taxable income, then continuing with our previous example, this would mean that let’s say we re-do some calculations, apply to them tax deductions, and now it turns out that $100 is taxable income while $400 is non-taxable income. Thanks to the tax deduction, your taxable income has now decreased. That’s great news for you!
The IRS allows you to deduct some things from your gross income, or in other words, they allow you to make some “adjustments.” Following these adjustments to the gross income, you end up with your “Adjusted Gross Income,” or AGI.
Next, we get to have two possible types of deduction applied to our Adjusted Gross Income.
One of them is called a “Standard Deduction,” which is given to you by the IRS based on your filing status: single, married, filing jointly, being head of household, etc (each of these statuses entitles you to a certain amount of deduction); the other is called an “Itemized Deduction,” and it consists of charitable, medical, house mortgage, and personal property tax deductions. The “itemized deduction” is also called the “schedule A” deductions, because it requires you to fill out the schedule A form, which people sometimes refer to as “the long form.”
So, you compare these two see which deduction is GREATER (in other words, which of these two turns out to grant you the larger deduction) and then you select the one that is larger.
Once you have made your choice of deduction and subtracted it from the Adjusted Gross Income, you now also get to subtract your exemptions, which is a deduction that you receive according to the number of dependents you claim on your tax return (exemptions include yourself if you are single, your spouse if you are married, your children if you have kids,etc).
After you have taken into account the standard or itemized deductions and the exemptions and subtracted them from the Adjusted Gross Income, you are left with your Taxable Income, which as was discussed before, is the amount of income that you earned that is taxable to you, meaning that this amount of income is fair game to be taxed and you will most likely pay a portion of whatever that taxable income number turns out to be to the IRS.
So, from the taxable income, we can determine what the tax you have to pay will be. There are two ways to determine what your tax will be:
- Look at tax rate schedule
- Look at tax table
Now is a good time to quickly review what tax deduction and tax credit are, and what the difference is between the two.
Tax Deduction – reduces the amount of TAXABLE INCOME
Tax Credit – reduces the amount of TAX LIABILITY (Tax liability = The actual tax payment you have to make to the IRS = Tax)
And recall that your TAXABLE INCOME is not your TAX. Your TAX turns out to be a portion of your TAXABLE INCOME.
So, once you have determined your taxable income, you will use it along with either of the two methods (1) and (2) to figure out what your tax (the payment you have to make to the IRS) is. We will go more in depth on how to use these two methods in a subsequent lesson.
Once you have determined an amount for your tax, you need to subtract tax credit from that amount (remember, the tax credit reduces the amount of tax), and then add any additional taxes (there could be many types of additional taxes to pay, but as an example let’s say you take money out of your retirement funds before you reach retirement age; you will be taxed for having done that). Once you have finished carrying out the arithmetic, you will be left with your Tax Due, which is what you will finally end up paying to the IRS (assuming it turns out that you owe them money).
As an example, let us say that your taxable income was $10,000, and through using either methods 1 or 2, you found what your tax was, and then subtracted tax credit and added additional taxes, and found that your tax due is $5,000.
But recall that as you were working throughout the year, you were paying the IRS by having a certain portion of your paycheck extracted and sent to the IRS, so they have already received some payment from you. The question is: does the amount of money that the IRS received from you throughout the year exceed or fall short of the tax due?
Once you answer that question, it will determine whether the IRS owes you a refund because you overpaid (your withholding ended up summing to more than the $5,000 tax due) or you owe the IRS money to fill in the gap in payment (your withholding did not add up to $5,000 and you need to pay some additional money to make up the amount still needed to reach $5,000).
So, in order to get how much you owe the IRS, you must subtract the amount of your withholding from the tax dues. Another item that must be subtracted from the tax dues is “payments – quarterly estimated,” which are payments made directly to the IRS. This applies mainly to self-employed individuals, who do not have an employer company that automatically extracts money from their paycheck and sends it to the IRS. Since they are self-employed, they must do this themselves, so they do not subtract withholdings from tax dues, they subtract payments – quarterly estimated, meaning that every three months they make payments directly to the IRS to remain in compliance. The rest of us (or those that are employees at a company/business) indirectly pay the IRS every time money gets taken out of our paychecks and sent to the IRS through our employer. So, generally you are either one or the other (withholdings or payment – quarterly estimated).
Some of us, however, even as employees working for a company, can also make direct estimated payments to the IRS if we don’t think that we will have paid enough into the IRS through our company’s automatic tax withholding (because there are penalties for not having enough paid in, so some people take the steps to make direct payments, as well, to ensure they do not get these penalties).
Continuing our example above, let’s say I am an employee and my tax due is $5,000. My company takes care of my withholdings and I make no direct payments to the IRS. Let’s analyze situation in which I get a refund and in which I have to make a payment.
That is all for this lesson on basic income tax. I hope I made my explanations clear enough to those that were interested enough to read. I will post the next one once I am done watching the next video in the playlist. I recommend watching the videos, as well, because the instructor is very good.