As the old saying goes, only two things in life are inevitable. One is a mysterious abyss that strikes fear in the heart of all mortal men, and the other is death. You might think that something so important as the tax system would be taught in public schools, or taught by our parents, but my experience shows that this is completely untrue. Most of us enter adulthood having no clue how taxes work.
I understand the anxiety. You have to file taxes every year, but nobody seems interested in teaching you even the basic concepts of taxation. We trust a critical, and sometimes expensive, part of our life to “experts” and software without even a fundamental understanding of the black box of numbers and regulations within.
That’s why I’m here to help. This post is not a “how to file taxes” post (that comes later). It’s a “how do they even determine what I owe?” post. Think of it as a general theory of taxation. I’ll put key terms in bold throughout the post. By the time you reach the end, you might not be able to fill out a Schedule C form for your sole proprietorship, but you’ll know the difference between a tax deduction and a tax credit.
Follow me along the path of determining your tax liability, and you’ll learn what you should have been taught in school about a topic that actually matters in your life.
Disclaimer: this is not tax advice, and I am not a certified tax professional. I’m speaking as a young adult who has filed taxes and helped others file theirs.
Step 1: Earning Money
This is probably the hardest step for most of us. Earning money is tough. However, it’s no use learning how taxes work if you don’t have an income with which to pay taxes. We start with a number: how much money did you actually earn for your work? For our purposes, let’s assume your household (you and your spouse) made $50,000 last year combined. This number is your gross income.
Step 2: Exemptions
Right off the top, the IRS allows us to claim exemptions. Exemptions mean that we can claim “this money can’t be taxed because I am breathing air.” There’s a limit, of course. You can’t just claim infinity plus one exemptions and the IRS owes you a Coke. You typically get one for yourself, one for a spouse, and one for each dependent in your household. This year, each exemption is worth $4,000.
In our example, my $50,000 of taxable money becomes $38,000 because I have a wife and a dependent son (three exemptions means I protect $12,000). This is a pretty sweet deal, and it’s designed to ensure that the poorest of the poor are protected from being taxed on necessary income.
Step 3: Deductions
In addition to the personal exemption, the IRS allows a laundry list of tax deductions. In a nutshell, you can do certain things with your money to prevent it from being taxed. The IRS says “if you spend a dollar doing these things, we will not tax that dollar.” Take note that a deduction and a tax credit are two different things.
Since the list of deductions is mind-numbingly long and requires pretty extensive documentation, the IRS generously allows for a standard deduction to simplify the process. If you’re a young adult who isn’t wealthy, you’re probably going to want to take the standard deduction as opposed to itemizing deductions. Itemizing requires listing each deduction separately with verification, and unless you’re giving $1,000 a month to charity or own a home, you probably won’t reach the threshold where your itemized deductions are larger than the standard deduction ($6,300 a year for singles and $12,600 for married couples).
In our example, let’s take the standard deduction for our married couple and be done with it. My $38,000 of taxable money is now $25,400. This is what the IRS calls your taxable income, or the amount of income actually subject to taxation. It might be interesting to note that a typical middle class family is only actually paying taxes on roughly half of what they make in a year.
Step 4: Tax Rates
OK, so this is probably the hardest step to understand. It’s also easily one of the most misunderstood concepts in government. Let me break it down.
How people think taxes work
For every dollar you earn, the government takes 35%. Simple enough, right? That’s SO MUCH TAX!
If this were true, then in my $50,000 example (which puts me in the 15% marginal tax bracket), I would owe the IRS $3,810.
How taxes work in reality
If you earn a little bit, the IRS takes a little bit. After you reach a certain threshold, the IRS takes a higher percentage of every additional dollar above that threshold.
In our example, I have $25,400 in taxable income. The first $18,451 is taxed at 10% (the IRS needs $1,845 of that income). For the next $6,949 they take 15% (they need $1,042 of that income). My total gross tax, or the amount the IRS needs from me, is $2,887.
Not to belabor the point, but people often fundamentally misunderstand tax brackets. They’re called marginal tax rates because that tax rate only applies to the “marginal” (meaning first additional) dollar above the previous tax bracket threshold. Billionaires do not pay 39.6% on everything they earn. They only pay that rate for every dollar above around $460,000 if they’re married.
Step 5: Tax Credits
Remember how deductions work? The IRS says “if you spend a dollar doing these things, we will not tax that dollar.” Tax credits are similar, with a twist. The IRS says “if you do these things, we will consider that as a substitute for paying us taxes.” Essentially, you can pay someone else instead of the IRS.
These are usually really popular programs that target the middle class. Common tax credits include the Child Tax Credit of $1,000 per child just for having children, Child and Dependent Care Credit allowing you to keep money you’ve paid for childcare, and the American Opportunity Tax Credit for college tuition. Every dollar you receive in tax credits reduces your overall tax bill for the year.
In our example, I owe $2,887 after Step 4. I have a child, so I claim the Child Tax Credit and reduce my tax liability to $1,887. In essence, the IRS has forgiven $1,000 of my tax bill. This total is my actual amount of tax owed.
Step 6: Withholdings
After all of these calculations, I’ve figured out how much I owe the IRS this year. No matter how big or small this amount is, it would kind of suck to have to pay it in one lump sum every April. Luckily, very few people do this.
If you work a typical job, you probably have taxes withheld from every paycheck. If I’m paid every two weeks, I might try to withhold $150 from every paycheck to cover my tax owed. This is where refunds come in.
Most people pre-pay their taxes through withholdings. When you file your taxes, the key numbers are how much you earned, and how much you withheld. These are found on W-2s or 1099s for most of us. By inputting these amounts on your tax forms, the IRS calculates how much you overpaid or underpaid throughout the year. Most of us overpay our taxes to the tune of around $3,000 per year.
Lots of folks believe that getting a huge refund is a good thing. It’s like a bonus in April! The key point here though is that a refund does not mean you pay less in taxes. It just means you paid them too early. You might find joy in that, but I personally would rather keep my own money throughout the year rather than giving the government a 12-month interest-free loan of a couple grand.
Hopefully you found this to be a thorough tutorial on how taxes work. Look for the next post in this series, where I’ll cover how to actually file taxes.
Did I miss anything? Are any sections unclear or difficult? What other tax topics would be helpful? Let me know in the comments below.