Individual Tax Basics

I recently filed my tax returns on TurboTax. It's so easy - you don't need to know anything about taxes. In my case, all I had to do with import my W2, answer a dozen questions, and I was done. I didn't know anything about the actual calculations, which is really convenient since I don't have to know the specifics but my ignorance also made me uncomfortable. How do I know these numbers are even right? I don't need to be a tax expert but I feel like I should at least know the basics to estimate my tax obligations so I know I'm at least not being cheated. It also seems like one of those things you should know as a working citizen.

So I decided to do some reading about the basics of how taxes are calculated.

Taxes are money collected by the IRS (Internal Revenue Service) to fund public or common resources such as firefighters and police on the city and state level as well as social welfare programs such as Social Security, among many other things. They're collected from both individuals as well as organizations, although not every individual or organization is obligated to pay taxes. Tax exemption is freedom from tax obligations, and many non-profit organizations are tax-exempt. Individuals can also be tax exempt depending on their level of income. 

Other than those that are tax exempt, any entity that's generating revenue in the U.S economic system is obligated to pay taxes. In this post I'll explain the taxation rules for single individuals since that's what applies to me. Different rules may apply to companies or married couple (yes, that matters).

Before the IRS can determine anything about your tax obligations, they need to know your total income or your gross income. This is the total amount of money that you earn in a year. If you work one job, then it's your salary plus any bonuses you received during the year. If you work multiple jobs, then it's the sum of all of your salaries. 

If you're lucky enough to make enough to owe taxes, there are two main types of taxes that you'll have to pay.

Income Tax

This is the tax that is collected from the money you earn from your job. There are two types of income tax. One is the federal income tax and the other is the state income tax. Not all states have income tax so not everyone has to pay state income taxes. However, everyone who is obligated to pay taxes must pay the federal income tax.

The income tax system in the U.S is known as a progressive tax system. In a nutshell, this just means that different tax rates are applied to different levels of your income. Which levels of income those rates apply to depends on your filing status. All of this information is all specified in a tax bracket table. 

Fortunately, for most of us our income tax amount is not collected based off our gross income. They're collected based off of our total taxable income. This is the amount that is actually subject to the income tax after certain deductions are applied. Deductions are any payments that reduce your taxable income. For example, your donations count as deductions and you have the option of claiming donations as deductions. So if you earned $10,000 this year in total and donated $1,000 to charity, you can claim a deduction of $1000 and end up with a taxable income of only $9,000. 

There are two types of deductions: automatic ones and manual ones (I made these terms up). 

Your 401K contributions are automatically deducted from your paycheck. And so are your monthly dental and health insurance premiums. Now at the end of the year when you file your taxes, you can specify more deductions (manually).

You get two options for claiming deductions manually when you file. You can either choose to take the standard deduction, which is $6,300 this year. Or you can choose to itemize. You cannot do both. All itemizing means is listing the payments that you want to claim as deductions (student loans, donations) to be applied to your taxable income. Which option you go with depends on which results in the largest deduction because you want to minimize your taxable income. 

FICA Tax

FICA stands for the Federal Insurance Contributions Act. It's a law introduced as part of the New Deal during the FDR administration in the 1930's when the Social Security program was established to aid retirees and the disabled. 

The FICA Tax today consists of the social security tax and the medicare tax. It's also known as a payroll tax because it's deducted from paycheck to paycheck for both the employee and employer. In 2016, employees are pay 6.2% in Social Security tax and 1.45% in medicare tax. 

The FICA Tax amount is pretty much the same as your taxable income less the 401K contributions. Unfortunately, the FICA Tax applies to 401K contributions.

Other types of taxes

Property Tax

If you own property, then you have to pay taxes based on the value of that property. Depending on where your property is, you may be paying the county or state depending on which has jurisdiction of the property.

Goods and Services Tax

As a consumer, I may have to pay taxes every time I buy a good or service. That's known as a sales tax and it's just one type of goods and services tax. Not all states have sales taxes.