Welcome to the world of tax forms, withholding, and tax deadlines.
Taxes are the price we pay for civilization, according to Oliver Wendell Holmes.
In fact, the first day on your new job you’ll be presented with an IRS form w-4. It’s like a rite of passage into adulthood.
Even families that talk openly about money don’t often discuss the arcane details of the W-4.
My sons certainly hadn’t prepared their own returns when they left home. They were daunted by the 207 pages of instructions for the IRS 1040, the standard income tax form.
So here, in more than 140 characters, and less than 207 pages, is my guide to income taxes for the beginning taxpayer.
You pay a portion of your income for taxes
Wages, commissions, interest paid to you on your money, and gain on the sale of assets are all forms of income.
The starting proposition is that income is taxable.
Gifts and loans are not income. Gifts might be taxable to the person who gave you the money, but not to you, if you’re lucky enough to be the recipient of the gift.
Not all income is taxable
You get to deduct from your gross income certain exemptions and deductions.
The balance after subtracting those amounts is your taxable income.
That creates the appeal of “write offs” and “deductions”. Those items reduce the total on which you figure your tax.
As income increases so do taxes
The range of income subject to a given tax rate is a “bracket”,
Each successive bracket applies a higher rate to the income that falls in that bracket.
There were 7 tax brackets for 2017.
Here are the brackets for a single taxpayer.
- Up to $9,325: 10%
- $9,326 to $37,950: 15%
- $37,951 to $91,900: 25%
- $91,900 to $191,650: 28%
- $191,650 to $416,7004: 33%
- $416,700 to $418,400 : 35%
- $418,400 or more: 39.6%
If you are lucky enough to have more than $418,400 in annual taxable income, you don’t pay 39,6% on all of that income.
Each tier of your income is taxed at the rate for that tier, or bracket.
So, your first $9,325 in taxable income triggers a tax at 10% , or $932
If you actually had a total of $25,000 in taxable income, you pay tax of 15% on all the income over the $9,325. You would have $16,075 of taxable income subject to the 15% rate, for a tax of $2411 on the excess over the first tax bracket.
Your total tax on $25,000 in taxable income would be $3343 ($932 + $2411).
Understand the marginal tax rate
We often speak of our marginal tax rate. That’s the percentage of the last dollar you make that’s owed as tax.
Looking at the tax table, a single tax payer who had $37,950 in taxable income was in the 15% bracket. If he had earned one dollar more, tipping into the next bracket, he’d pay a tax of 25% on that extra dollar that falls in the higher bracket.
His marginal rate is 25%. That doesn’t mean he pays 25% of his income in tax.
He pays the higher rate on just the income that exceeds the top of the lower tax bracket.
Effective tax rate vs. marginal rate
Our fictional single tax payer with taxable income of $36,251 had a marginal tax rate of 25%. That tells you how much of any increase in taxable income he’ll get to keep.
His effective tax rate is the percentage of his total income that is paid in tax. That’s a far lower percentage.
It’s lower because there are adjustments “above the line” that reduce the income on which you pay tax, and then there are deductions and exemptions that further reduce the amount of income that is subject to tax.
Our examples here look at the taxable income so we could understand tax brackets and tax rates.
Tax law requires that we pay this year’s taxes in advance, even though the final tax return for this tax year isn’t due til next spring.
Employers are required to withhold your estimated taxes from your paycheck. You, however, get to tell them how much tax you expect to owe.
Whoa! How can you know how much you’ll owe next spring if you’re a new taxpayer. Don’t worry, there’s a form for that.
IRS form w-4 includes a worksheet where you calculate how many tax allowances match your situation. It’s 8 lines and produces an approximation of what you’ll owe.
Your employer uses the number of allowances you claim to figure how much tax to withhold from each check.
The approximating your taxes is tricky: withhold too little, and you pay a penalty with your return for having paid too little in advance: withhold too much, and you get a refund with your return, for having made an interest free loan to the feds.
You can change your w-4 if your circumstances change during the year or you get a better estimate on what you are likely to owe.
Taxes for the do-it-yourselfer
If you are new to the tax paying world, your financial life is probably fairly simple. Take the time to learn how to prepare your own tax returns while things aren’t too complicated.
There is free tax software available through the IRS, as well as the commercial tax software. My experience is that the big tax preparation services don’t always do a good job. You’ll probably get a better product and save some money preparing your own return.
Another time, we’ll look at exemptions and deductions and other tax mysteries.