The Very Basics of Income Taxation

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Despite being the system all of us have spent our lives beholden to, I’ve found very few individuals fully understand how our government taxes personal income.  This article will be a brief overview of how it works from a very general perspective, focusing on the bottom-line question: “How much will I owe for income taxes this year?”

To arrive at this figure, you must first know your tax filing status as each designation is associated with a different set of tax brackets.  There are four primary filing categories, from which you must choose the one most accurately describing your situation.  Those are: Single, Married Filing Jointly, Married Filing Separately, and Head of Household.  For help determining your filing status, visit the IRS website.

Once you know your tax filing status, you must then arrive at your taxable income.  For most people, this figure is substantially less than their total, or “gross,” annual income as you must first subtract all the various deductions, exemptions, and adjustments before arriving at the taxable income amount.  After trimming the gross income down to what will be taxable, you then apply that number to the relevant tax brackets associated with your filing status designation- and this is the area where we find the most confusion about how marginal or “progressive” taxation works.

First, let’s take a look at one example of the tax brackets.  This is the breakout for a single filer in 2017:

We run into a lot of folks who are under the impression that a single dollar of additional income can cause all their income to be taxed at a higher rate if it bumps them into a higher tax bracket.  As indicated by the chart above, this is clearly not the case.  Though it is true that those reporting less taxable income may fall into a lower tax bracket, thus owing less overall, everyone enjoys the same wonderful journey as they progress through the ranks.  In other words, all else being equal, if you are a single filer, you and your single-filing neighbor will owe the same 15%, or $5,226.25, on $37,950 of taxable income.

However, if you are fortunate enough to make more than that, any additional dollars of taxable income will traverse successively higher tax rates, meaning the income may cost you more to earn, from a taxation standpoint.  So, to reiterate my primary point, earning $38,000 does not mean you will now pay 10% higher total taxes than your neighbor, but, rather, you will only owe 10%, or $5, more on the $50 of taxable income above the cutoff of $37,950.

The final step in arriving at your overall taxes owed is applying any tax credits for which you may be eligible.  Unlike deductions, which are subtracted from gross income to arrive a taxable income, credits directly offset the amount owed to the IRS.  So, for example, if you owe $3,000 in taxes, a $1,500 credit will reduce the amount owed to $1,500.  Some credits are even “refundable” which means the IRS will actually pay the money back to you in the form of a refund if you have already zeroed out your tax liability for the year.

As a disclaimer, the information above is intended to give readers a general overview of how the taxation process works in the United States.  There are many caveats and special circumstances that may alter the calculation for each taxpayer, thus consultation with a qualified tax professional is always strongly encouraged.

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