How does the government calculate how much you owe in taxes? How does your tax bill change depending on your income and family situation? Everyone dreads taxes, but if you know how they work, you will be able to reduce the taxes you owe.
How Income Tax Works
Income tax is based on how much income you earn. In most countries, income tax is progressive, so you pay a higher percentage if you earn more income. You also might need to pay a separate income tax for your state or province.
What percentage of tax you must pay is determined by your tax bracket, the range of incomes taxed at a specific rate. Brackets act like buckets where all the money in a certain range is taxed at the same rate.
Imagine your income is like sand filling a bucket and each subsequent bucket is taxed at a particular rate. So if the tax rate is 15% on the third tax bracket of $20,000-$40,000, and you make $35,000, that does not mean that the tax on all of your income is 15%. The first $10,000 you earn might be taxed at 10%, the next $10,000 might be taxed at 12%, and then the last $15,000 would fall into the third bracket and be taxed at 15%.
Tax withholding, also known as Pay As You Earn (PAYE) in the UK or Pay as You Go in Australia, is the income tax or other taxes that your employer takes out of your paycheck. The advantage of having taxes withheld from your paycheck is that you don’t have to remember to set aside your own earnings to pay taxes.
Your employer determines how much to withhold based on your income. In the U.S., you can also choose to withhold more than you are required if you know you will earn other income that is not on your regular paycheck. In the U.S., at the end of each year, you submit a tax return to declare your total taxable income and the amount of taxes you have already paid. If you still owe more taxes, you must pay the difference, and if you have overpaid, you receive a refund.
If you have your own business or work as an independent contractor, meaning you are not an employee and you don’t receive benefits from the company you work for, you must calculate how much income tax and other taxes you owe and pay them manually to your government. In the U.S. self-employed people must estimate how much they are earning and pay taxes on that amount 4 times a year, not including filing a tax return. They also must pay a higher percentage than regular employees for other taxes such as Social Security and Medicare since they don’t have an employer contributing to them.
Nevertheless, there are some tax benefits to being self-employed or having your own business, such as being able to deduct business expenses.
Tax Deductions and Tax Credits
Tax deductions reduce the amount of your income that is taxed, indirectly lowering your tax bill. For example, one deduction in the U.S. is the Flexible Spending Account (FSA) deduction for health expenses. If you make a salary of $70,000 and you put $1000 into a PSA, your taxable income would be $69,000 before accounting for other deductions or credits. In the UK, deductions are known as tax relief provisions. Some provisions include donating to charity or contributing to your pension fund.
Tax credits directly reduce the taxes you pay by the amount of the credit. Unlike deductions, credits directly eliminate a certain amount of taxes that you owe. If you receive a tax credit of $400, and the total amount of income tax is $6000, you will now only owe $5600.
Credits apply to specific situations determined by the tax code. For example, in Canada, you can claim some amount of the tuition for higher education programs as a tax credit if you are between 26 and 66 years old.
Standard Deduction vs. Itemized Deductions
In the U.S., there is a standard deduction that reduces your amount of taxable income by a fixed amount. In the UK, there is a similar provision known as a Personal Allowance. These deductions exist to make it easier to file your taxes, since they lower your tax bill without requiring you to list out all of the available tax deductions you qualify for.
You must choose between the standard deduction and itemizing your deductions, which means listing out all your deductions. Many people choose the standard deduction if their itemized deductions would not add up to more than the standard deduction. The main reason people itemize their deductions is if they would benefit from large deductions. For example, if you can deduct the interest you pay on a mortgage for your primary residence, that interest might add up to more than the standard deduction.
There are a few deductions that people can take on top of the standard deduction, such as using a Flexible Spending Account (FSA) for healthcare expenses or donating to charity.
Tax Filing Status
In the U.S., your income tax rate depends on your filing status, your official status in the eyes of the government. These filing statuses are taxed at different rates because the government uses the tax code to incentivize marriage and to provide more tax deductions for people who take care of children or relatives. The different filing statuses are single, married filing separately, married filing jointly, head of household, and qualifying widow or widower.
If you are single without dependents, children or other relatives who rely on you for most of their expenses, you are classified as ‘single’. If you are married, you choose between ‘married filing separately’ or ‘married filing jointly’. If you are single and have dependents, you file as ‘head of household’, and you file as a ‘qualifying widow or widower’ if you are a widow or widower who meets the requirements. For married couples there are usually more tax advantages to filing jointly.
Dependents are children or relatives who rely on someone else for most of their living expenses. In the U.S., dependents must meet certain qualifications, such as not making more than an allowable amount of income. If you claim a dependent on your tax return, you can usually receive more tax deductions and credits which can reduce the total amount of income tax you must pay. Some credits that people with dependents may qualify for in the U.S. include the Child Tax Credit or the Earned Income Tax Credit.
For example, Casey has a minor child that she can count as a dependent on her taxes. Having a dependent and having income below a certain threshold qualifies her for the Child Tax Credit, which reduces her tax bill directly by $2000. She may end up having a tax refund when it comes time for her to file her taxes, depending on how much taxes her employer has withheld from her paycheck.
Tax Returns and Tax Audits
A tax return is a form where you report the income you received from all sources. In the U.S., you are required to file a tax return if you make more than a certain amount. Other countries, such as the UK, only require you to file a tax return under certain circumstances such as being self-employed or receiving income from sources other than your job. If you file a tax return and find out that you have paid more taxes than necessary, then you receive a refund. If you find out that you owe more taxes, you must pay them by a certain deadline.
Sometimes the government conducts tax audits. Audits are an inspection of your financial records. They essentially check that you are not cheating on your taxes. They require you to submit documentation of your income and your eligibility for any deductions or tax credits you have claimed. Although the risk of being audited is low, it’s still better to keep all financial documents related to your taxes in case you are audited.
Capital Gains Taxes
If you have investment income, such as dividends from stocks, or if you sell an asset that has appreciated, such as a house, you will owe a different type of taxes on this income called capital gains taxes.
Capital gains taxes are usually taxed at different rates than income tax, and they are only due after you sell the investment or security. There are different tax rates for short-term gains, meaning the profits from an investment you bought and sold within one year, and long-term gains, meaning the profits from selling an investment you have held for more than one year.
For example, Casey buys $50,000 in stock in one company. After10 years, Casey sells it for $95,000, almost double the original price. Since she gained $45,000 from when she first bought it, she is taxed on that amount at the capital gains tax rate. Capital gains are treated separately from income, so the $45,000 she made from selling her investment does not count as her regular income.
How to Plan for Taxes
For people who only have one main source of income and are not self-employed, it is easy to plan for income taxes since they are regularly taken out of your paycheck.
However, you might realize you are withholding too much if you regularly receive a large refund. In that case, you can adjust how much your employer withholds from your check for taxes.
If you are self-employed and have other sources of income that significantly increase the income taxes you owe, then you need to estimate how much your total income will be for the whole year, what deductions and credits you will be able to take, and then calculate how much extra you need to withhold from each of your paychecks. If you do not do this, you will have a larger tax bill at the end of the year, which you could save for and pay in a lump sum.