Introduction to INcome Taxes
In the United States, a percentage of all the money that individuals and businesses earn and spend is collected by federal, state and local governments for use in public spending. Individuals and businesses are required to pay various kinds of taxes, such as sales tax, property tax, payroll tax, and income tax.
Income taxes are the primary source of revenue for the federal government. Many states, and even some towns and cities, also impose income taxes. For many individuals, federal income tax is the largest category of tax they pay. So to be a good money manager, it’s important to understand some basic concepts about federal income tax:
- A tax return is a pre-printed or electronic form you fill out to report information that the federal Internal Revenue Service (IRS) uses to calculate your taxes. One example of a federal tax return is an IRS Form 1040.
- Filling out a tax return form and submitting it to the IRS is called filing your taxes. Some people hire a professional to fill out their tax forms while others do the work themselves.
- Before you can determine which IRS form to use when you file, the amount of your standard deduction, and your correct tax, you must determine your filing status.
The Filing Basics
Before you get started, be sure to know the filing basics.
There are five filing statuses:
- Married, Filing Jointly,
- Married, Filing Separately,
- Head of Household, and
- Qualifying Widow(er) with Dependent Child
You also use your filing status in determining whether you are eligible to claim certain other deductions and credits. If more than one filing status applies to you, choose the one that will give you the lowest tax.
The term withholding refers to “pay-as-you-earn” taxation. It’s when your employer takes out a certain amount from your check to pay taxes to the government. If you are an employee, at the end of the year, your employer will issue you an IRS form W-2 that summarizes your taxable wages and the taxes that the employer has deducted or “withheld,” from your pay. Independent contractors receive a form 1099 listing the amount they were paid.
A tax refund is an amount that the government gives back to you if you have paid more taxes than were due.
If you are a U.S. citizen or resident alien, whether you must file a federal income tax return depends upon your gross income, your filing status (see below), your age, and whether you are a dependent (i.e., you depend on someone else for financial support).
The amount of income tax you pay is based on your gross earned income (salaries, wages, tips, and dividends if you own stock) plus unearned income (for example interest income, dividend income, or capital gains), less deductions, exemptions or credits. The resulting amount — the amount that is subject to federal income taxes—is called your taxable income.
A deduction is an amount that reduces your taxable income and therefore reduces the tax to be paid. The federal government offers a number of different kinds of deductions.
The standard deduction is a dollar amount set by the federal government that reduces the amount of income on which you are taxed. Most taxpayers have a choice of taking a standard deduction or itemizing (separately listing) their deductions. If you have a choice, you can use the method that gives you the lower tax.
Taking the standard deduction can make it quicker and easier to file your taxes; however, many taxpayers choose to itemize their actual deductions, such as medical expenses, charitable contributions, and taxes.