Taxes
What Are Taxes?#
Taxes are fees we pay to the government to fund things for the general population like infrastructure, public health services, public education, and more. There are different types of taxes like sales tax and property tax, but when we talk about filing taxes here in the U.S., we're generally referring to income tax, which is what this section will be focused on.
Income tax is a tax on the wages, salaries, and other types of income you earn. The federal income tax is levied by the Internal Revenue Service (IRS). You will also pay state income tax unless you live in one of these 9 states: Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming, Tennessee, and New Hampshire (mostly). We'll be talking about the federal income tax in this section, but note that your state might have its own tax too.
Who Should File Taxes?#
Most working adults will have to pay federal income tax, but it depends on your filing status, age, and income. For most people, you'll look at the following table to determine if you owe taxes.
| IF your filing status is... | AND at the end of 2020, you were... | THEN file a return if your gross income was at least... |
|---|---|---|
| Single | under 65 | $12,400 |
| 65 or older | $14,050 | |
| Married filing jointly | under 65 (both spouses) | $24,800 |
| 65 or older (one spouse) | $26,100 | |
| 65 or older (both spouses) | $27,400 | |
| Married filing separately | any age | $5 |
| Head of household | under 65 | $18,650 |
| 65 or older | $20,300 | |
| Qualifying widow(er) | under 65 | $24,800 |
| 65 or older | $26,100 |
If your parent or guardian can claim you as a dependent or if you fall into one of the other special situations, see the instructions for IRS Form 1040 to see if you have to file taxes.
How Do Taxes Work?#
We'll go through the process step-by-step. First you earn income. Not all of that income is taxed, so we have to calculate your taxable income. On your taxable income, you pay payroll taxes and income tax. You'll receive a W-2 Form which states how much you paid this year in taxes. Then, you'll file your taxes to see how much you actually should have paid. After determining if you overpaid or underpaid, you'll either be refunded or owe additional money.
We'll take a closer look at how taxes work. You probably won't need to do any calculations yourself when you do your taxes if you use a tax software and e-file your taxes, but it's good to get an understanding of how it all works. If you'd prefer a more interactive way to learn about some of these topics with learning modules, examples, and comprehension questions, check out Understanding Taxes created by the IRS.
1. Taxable Income#
You earn income, but you don't get taxed on all of it. Taxable income is the portion of your income that gets taxed. You start with your gross income which is all the money you earn from all sources. Then, you subtract any applicable adjustments to calculate your adjusted gross income (AGI). Finally, you subtract any applicable deductions to calculate your taxable income. We'll talk about gross income, adjusted gross income, and taxable income, and then look at an example.
1.1 Gross Income#
Gross income is the sum of all the money you earned in a year. This includes your traditional salary and wages from an employer, any income you made if you're self-employed, interest income, dividend income, etc. We'll focus on two sources that you're most likely to have (compensation and interest income) and list some examples of more uncommon sources.
1.1.1 Compensation#
You get compensated for your work with money. You could be compensated with:
- wages - getting paid at an hourly rate
- a salary - getting paid a fixed sum for a period of time
- commissions - getting paid based on a pecentage of sales
- bonuses - getting paid extra in addition to your usual compensation
- tips - getting paid extra by a customer voluntarily
This income gets reported on your W-2 Form (more on this later). Your employer will send this to you.
1.1.2 Interest Income#
At this point, you should hopefully know what interest is. Recall that interest is the cost of borrowing money. Interest income is taxed if you earned more than $10 and is earned from savings and checking accounts, U.S. bonds, mutual funds, certificates of deposits (CDs), etc.
Interest income gets reported on a 1099-INT Form. Your bank, brokerage firm, or other financial institution will send this to you.
1.1.3 Other Sources of Income#
There are many other sources of income that you may have but we didn't cover, such as dividend income, unemployment compensation, social security benefits, retirement income, stocks or investments sold, etc. Most of these are reported on their own forms which usually have 1099 in the name, like the 1099-INT form for interest.
Other sources of income are more uncommon, such as income from owning your own business or gambling winnings.
We won't cover these for the sake of brevity, but your tax software or tax professional should be able to guide you through these.
1.2 Adjusted Gross Income (AGI)#
From your gross income, we subtract certain adjustments like college tuition and fees, student loan interest, health savings account (HSA) contributions, etc. to calculate your AGI. Your AGI is going to be equal to or less than your gross income, which means you're reducing the amount of taxable income you have. The Schedule 1 1040 Form lists all the adjustments you can make to your gross income.
1.3 Deductions#
A deduction is subtracted from your AGI to and results in your taxable income. A larger deduction means less taxable income.
You have the option to claim the standard deduction or to itemize your deduction. The standard deduction allows you to deduct a fixed amount from your adjusted gross income. A taxpayer filing as single in 2021 would be able to deduct $12,550 from their gross income, no matter what. The itemized deduction allows you to calculate the sum of all of your deductions including charitable contributions, medical and dental expenses, gambling losses, education expenses, etc1.
You should see if your itemized deduction is greater than the standard deduction to decide which one to claim, but generally, the standard deduction is going to be greater.
1.4 Taxable Income Example#
This was a dense section so let's put everything together so far in a simple example. Suppose you earned $80,000 this year from your salaried job. You also earn $100 in interest from your savings account. Your gross income is $80,100 ($80,000 + $100). You made a $1,000 contribution to your health savings account. Your AGI is $79,100 ($80,100 - $1,000). Like most people, you take the standard deduction so your taxable income is $66,550 ($79,100 - $12,550).
Now that we have our taxable income, we can start looking at what taxes we have to pay.
2. Payroll Taxes#
Payroll taxes are used to pay for government programs - namely Social Security and Medicare. These have a flat tax rate, meaning that everyone pays the same percentage. The Social Security tax rate is 6.2%, and the Medicare tax rate is 1.45%, so a total of 7.65% of your gross income goes to these programs. These taxes will be withheld from your paycheck by your employer.
3. Income Tax#
The amount you pay for income tax varies per person. When you start your job, your employer asks you to fill out a W-4 form. This tells your employer how much income tax should be withheld from your paycheck based on your personal information like your filing status, number of dependents you have, etc.
3.1 Tax Brackets#
Based on your filing status (single, married filing jointly, married filing separately, or head of household), you will fall into a particular tax bracket.
Here are the tax brackets for 2021 for single filers with rounded numbers in the "Tax Owed" column for simplicity.
| Tax Rate | Taxable Income Bracket | Tax Owed |
|---|---|---|
| 10% | $0 to $9,950 | 10% of taxable income |
| 12% | $9,951 to $40,525 | $995 plus 12% of the amount over $9,950 |
| 22% | 40,526 to $86,375 | $4,664 plus 22% of the amount over $40,525 |
| 24% | $86,376 to $164,925 | $14,751 plus 24% of the amount over $86,375 |
| 32% | $164,926 to $209,425 | $33,603 plus 32% of the amount over $164,925 |
| 35% | $209,426 to $523,600 | $47,843 plus 35% of the amount over $209,425 |
| 37% | $523,601 or more | $157,804.25 plus 37% of the amount over $523,600 |
Think of tax brackets as buckets. You fill up each bucket with your income. Once a "bucket" gets full, you have to move on to the next bucket.
Let's say your taxable income is $9,000 a year. You pour $9,000 into the first bucket, the 10% tax bracket. All of your money fits in the bucket, so your $9,000 gets taxed at 10%.
Let's say your taxable income is $50,000 a year.
- You start pouring your $50,000 into the 10% tax bracket. You fill this bucket completely with $9,950, so $9,950 gets taxed at 10%. You pay $995, and have $40,050 left.
- You continue pouring your remaining $40,050 into the 12% tax bracket. This bucket can hold $30,574 ($40,525-$9,951). You fill this bucket completely with $30,574, so $30,574 gets taxed at 12%. You pay $3668.88, and have $9,476 left.
- You pour your remaining $9,476 into the 22% tax bracket. All of your money fits, so your $9,476 gets taxed at 22%. You pay $2,084.72 and have $0 left.
By the end, you have paid $6,748.60 ($995+$3,668.88+$2,084.72) in income tax.
3.2 Marginal vs. Effective Tax Rate#
Your marginal tax rate is the tax rate you pay on an additional dollar of income. Suppose your taxable income is $50,000 a year, like the example in Tax Brackets. If you made an additional dollar, that dollar would be taxed at 22%, so your marginal tax rate is 22%.
Your effective tax rate or your average tax rate is the percent of your income that you pay in taxes. Suppose your taxable income is $50,000 a year. As we calculated in Tax Brackets, we pay a total of $6,748.60 in taxes. The effective tax rate would be 13.50% ($6,748.60/$50,000).
These two rates are often confused. For the average person, you'll want to pay more attention to your effective tax rate - it's a more accurate way of thinking how much you'll pay in taxes.
4. W-2 Form#
At the beginning of each year, your employer will give you a W-2 form which reports the following for the previous year:
- how much income you made
- the amount of payroll taxes deducted
- the amount of income tax deducted
This form assumes your compensation is your taxable income and doesn't take into account other sources of income, adjustments, or deductions we talked about in Taxable Income. This form shows how much in taxes you have already paid. Now, you go through the process of "filing your taxes" to see how much you should have paid.
5. Filing Your Taxes#
Filing your taxes seems pretty intimidating, but it's essentially just a matter of filling out a bunch of forms. These forms will help calculate how much you should have paid in taxes by accounting for all your sources of income, adjustment, and deductions. You'll also have a chance to claim tax credits which directly reduce the amount of taxes you owe. Let's take a closer look at the process2.
5.1 Personal Information#
First, you'll file some personal information about yourself. Basic information will include your name, address, social security number, and date of birth. You'll also provide your filing status and the number of dependents you have. Remember that your tax bracket is based on your filing status, so the government uses this information to help determine how much you should have paid.
5.2 Taxable Income#
Next, you'll file all sources of taxable income. For wages, you'll use the W-2 Form. For interest income, you'll use the 1099-INT form. There are a bunch of other possible sources of income to have that have their own unique form.
5.3 Adjustments and Deductions#
Then, you'll claim adjustments and deductions. Sometimes the terms adjustments and deductions are used synonymously since they both reduce the amount of taxable income you owe. You might claim adjustments or deductions like charitable donations, health savings account contributions, college tuition, student loan interest, IRA contributions, etc. Some of these will have specific forms associated with them and others just rely on you reporting the correct amount.
5.4 Credits#
Similarly, you'll then claim any tax credits. While deductions reduce your taxable income, tax credits directly reduce the amount of tax you pay. Let's reuse our taxable income example from Tax Brackets and after calculating your taxable income to be $50,000, you owe $6,748.60 in taxes. A $1,000 tax credit would directly reduce your $6,748.60 tax bill to $5,748.60. That makes credits more favorable than deductions since they reduce the tax due, not just your taxable income. There are credits for pursuing a college degree, owning an electric vehicle, paying a mortgage for a home, adopting children, and more. You'll claim whatever is applicable to you.
5.5 Refund or Bill?#
Finally, you'll see how much you owe the government or how much the government owes you after all of this number crunching. This money can be paid to or from your bank account directly.
Underpaying vs. Overpaying#
Remember that you can underpay or overpay your taxes.
If you underpay, you'll owe the difference to the IRS, and may even owe a penalty if you owe too much. But is getting a tax refund better?
You usually hear people getting excited about their tax refund. It's an sizeable influx of cash, and lots of people like to treat it like an extra paycheck for the month. It seems like something you should be happy about, but it's not a good thing. If you overpaid on taxes, that means you gave the government extra money to hold onto at 0% interest. That money could have been invested in a retirement account or been used to pay off debt. You should try to make sure you get as small of a refund as possible or maybe even owe a small amount by adjusting the information on your W-4.
How To File Taxes?#
Using tax software generally makes filing your taxes relatively easy since you just have to answer questions or enter in numbers from the forms you received. There are obviously more complicated scenarios and circumstances, in which case you might consider talking to a tax professional, but for the average person, e-filing is the way to go.
Tax Software#
There are quite a few options out there for tax software, some paid and some free options. These options are focused on federal income tax filing, and you should do your research for state income tax filing.
warning
You should be careful about what software and software version you end up going with. Some companies employ tricky tactics that get you to pay more for their products. If you haven't seen Why Doing Taxes Is So Hard | Patriot Act with Hasan Minhaj, you should check it out to learn more about how companies can deceive you into paying for their tax preparation services and how messed up the U.S. tax system and industry is.
Paid with Free Version#
Sometimes, the free version will be limited and not include all forms of taxable income, adjustments, or deductions. Popular choices that have tiered payment include TurboTax, TaxAct, H&R Block, and TaxSlayer. You're usually paying for brand name, pretty user experience, and ease of use here. In most cases, you do not need to pay this much for tax software and are better off using a cheaper or even free alternative.
Free with Qualifying Income#
Sometimes, the free version will only be free for people with income less than a certain amount. To see if you qualify for free filing based on income, you can check out the IRS's Free File Online Options. If you qualify, you should use one of these options or a straight up free option.
The IRS also has Volunteer Income Tax Assistance (VITA) and Tax Counseling for the Elderly (TCE) programs that offer free tax filing help for qualifying individuals (low income, disabilities, limited English, older than 60). You can see if you qualify and learn more here.
Straight Up Free 3#
Sometimes, the software is just free. All of the following software is free for federal tax filing. The IRS Free File Fillable Forms is like filing on paper and may require basic calculations. FreeTaxUSA is less manual than IRS Free File Fillable Forms and is pretty nice to use. CreditKarma is also an option.
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You should do your research on what software will cover your tax situation and make your own decision. The software listed above is just a starting point.
Other Methods#
You can have your taxes prepared by a certified public accountant (CPA), but that's probably overkill unless you have a complicated tax scenario (e.g. self-employed) or you would prefer saving some time. If you do decide to hire someone to help you prepare your taxes, just make sure they are a fiduciary. Fiduciaries have a legal obligation to act in your best interest.
You can also file your own taxes on paper, but you can get your taxes processed much faster if you do it online.
Getting Started#
You've read this section and you're ready to file your taxes. Here are some steps to get started, assuming you're e-filing your taxes:
- Start early. Taxes are due in April, but the sooner you start, the better. You may discover you owe extra taxes, in which case, you want to make sure you have the money ready to go. If you're owed a refund, you'll also be able to take your time and accurately file to get the most money back, and you'll get your refund sooner.
- Choose a tax preparation software. They all do the same thing, but some may cost more. Do your research to find a low-cost or free option if possible.
- Gather any tax forms. You will need to reference forms that were sent to you by your employer, bank, brokerage firm, university, or other financial institution. Assuming you have all your forms readily available, you can knock out your taxes in one sitting.
- File your taxes. Follow your tax software and fill out everything that applies to you. Make sure you're accurately filling everything out to get the biggest refund or smallest bill.
- Wait patiently. If you're owed money, you'll eventually receive your refund. It'll be faster if you gave your direct deposit information. Just keep an eye out to make sure you receive it.
- There are some limitations on how much you can deduct for each category so be sure to do your research before deciding to itemize your deductions.↩
- This description is relatively general and doesn't go too deep into the nitty gritty of specific tax forms used since taxes vary for each individual. This is to get a better idea of what the big picture looks like.↩
- If you're cognizant about digital privacy, you might wonder how some of these companies offer their products for free. The IRS Free File Fillable Forms is funded by the government. FreeTaxUSA pays for their free federal tax service through their paid state tax return service and other optional services. CreditKarma doesn't say how they fund their service, so it might be something to be wary about.↩