How Does Income Tax Work?

Remember the time that you got your first job? The time you felt like an adult and worked hours upon hours putting your customer service face on at a job that you hated, just so you can have some money to kick it with the homies? Remember your first upcoming paycheck and calculating exactly how much you’ve earned that paycheck until…BAM! Uncle Sam made a not so nice introduction to you. Little did you know that for every hour that you worked, Uncle Sam was happily right beside you, reaching into your pocket, and taking a little bit of that income that YOU earned for himself. What I am referring to is income tax – one of the main sources of revenue for the government. Although income tax is not the only source of income for Uncle Sam, it is a big portion of the government’s revenue. The time has arrived young grasshoppers, time to put on your learning caps (or fedoras for you sophisticated readers) because class is in session, and it’s time for me to drop some knowledge on you youngins’… or older youngins’, I don’t judge. Mr. Nahas, how does income tax  and tax brackets work? Funny you should ask little Timmy… I have comprised a list of the main components. The two main categories of income tax are: earned and unearned income. Knowing how income tax works can save you a lot of money!

Earned Income:

1. Salaries

2. Wages

3. Tips

4. Commissions

Unearned Income:

1. Interest

2. Dividends – Basically, a distribution of a company’s profits made to shareholders that is decided by the board of directors. We will go into further detail on a later date.

Mr. Nahas, how do tax brackets work? In the United States, we have a progressive tax structure. The more money you make, the money Uncle Sam is entitled to take from you; it’s a brilliant way to make money…if you are the US Government. For each income level, there is a following tax bracket that that you must pay depending on your filing status. I retrieved the following information below from Forbes for a single filer.

The picture above explains how income tax is progressively paid based on your income. As you can see, you are paying 22% on the amount of $39,475, not on 22% on all of it. It is a bit of confusing, which is understandable because the United States tax code is more complicated than “Don’t worry, I’m fine.”

Mr. Nahas, how do people get tax refunds or not have to pay any taxes? Ah yes, little Bobby, great question. There are two main ways to decrease the taxes that you owe. One is through deductions and the other is tax credits. I will do my best to explain the differences between the two.

Tax Deductions:  Deductions help lower your taxable income, so you take the deduction and subtract that from your taxable income. For example, let’s say that I earn $50,000 annually, that means I am paying a marginal rate of 22% for anything over $39,476 and under $84,201. So, I would pay 22% on $10,524 in my case, which would equal $2,315.28 on just that; I would still have to pay taxes for the lower amounts as well. Now let’s say I have a tax deduction of $10,000, my taxable income would be lowered to $40,000, which means I only pay 22% on the $524 instead of the $10,254. Don’t think that Uncle Sam doesn’t care about his nieces and nephews because he kind of does. The US Government offers a standard deduction of about $12,000 to single filers. There are itemized deductions but that requires you to fill out more forms, and you need proof that you qualify for them.  I did want to make a note that if you work for a company that offers a 401k (I will talk about that at a later time, but it’s a retirement fund that you and your employer contribute to) and a medical plan, then you are in luck because any automatic payroll contributions made to your retirement fund or your medical health plan will lower your taxable income. There are many different deductions, so I would consult with a tax professional to see which deductions would be the best for your situation.

Tax Credits:  Tax credits directly impact the amount of taxes that you owe. So, if you owe $1,000 after all the deductions, and you have a credit for $1,000, that means you owe nothing. There are several different types of credits available to the public, so consulting with your tax professional would be the most ideal thing to do to see what you qualify for.

On top of Uncle Sam’s tax, each state might have their own income tax as well. On top of income tax, you and your employer must split the payroll tax, more formally known as FICA tax. The government does have other kind of taxes like:

1. Capital gains taxes

2. Estate taxes

3. Inheritance tax,

4. Sales tax

5. Property tax

6. Excise tax

7. Some other tax that they have hidden that affects our money.

All right youngins’, I know this is a lot to take in, but it is necessary to this these adult things before you get blindsided by Uncle Sam and company. By no means am I a tax expert or an accountant, I just like to learn about these things in hopes of dropping knowledge. The world of taxes is a scary and confusing part of our way of life; there are so many loopholes and strategies people use to pay the least amount of taxes that they possibly can. Make sure your strategy is legal! Now you all know how the income tax bracket works!

 

 

Peace Out,

 

Mr. Nahas