Understanding Income Tax Laws

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Tax forms can be intimidating, and tax software doesn't necessarily make them less so. Income tax laws and rules can be intricate. Fortunately, some fundamental rules and principles can help you understand what taxes are all about, from the types of taxes to exempting income.

The Purpose of Taxation

The United States has a big budget. Maintaining schools, roads, hospitals, the military, and government employee wages and pensions eats up substantial resources. Taxing individuals and companies is the only way to raise the financial resources to pay for these social and civic needs.

Individuals and companies pay a percentage of their earnings to federal and state governments in the form of income taxes.

Congress and the President of the United States are responsible for writing and approving the country's tax laws. The Internal Revenue Service is responsible for enforcing these laws, and for collecting taxes, processing tax returns, issuing tax refunds, and turning over the money collected to the U.S. Treasury.

The Treasury is responsible for paying government expenses. Congress and the President are also responsible for establishing a federal budget. When the government spends too much money, it must raise more through taxation or increase the national deficit—money that the country has to borrow to pay for programs and services.

Everyone Is Subject to Taxes

Every person, organization, company, and estate is subject to income tax. This means that people and organizations must report their income on tax returns and calculate their tax due.

Some organizations are exempt from tax, but they still have to file returns, and their tax-exempt status could be revoked if the organization fails to meet certain criteria.

Nonprofits are exempt from paying federal income tax, sales taxes, and property taxes, but they do have to pay Social Security and Medicare taxes on behalf of their employees.

The amount of tax you owe is based on how much you earn. It's up to you to take control of your tax situation. You can reduce your taxes by taking advantage of various tax benefits.

Types of Income

Income is any money or compensation you work for it or returns received from invested resources. An investment could mean buying stock or buying a property from which you earn rental income.

Income includes:

  • Wages
  • Interest
  • Dividends
  • Profits on investments
  • Pensions and some other retirement benefits

It does not include gifts or inheritances, at least at the federal level.

Income is divided into two categories: earned and unearned. Earned income is anything generated from working, and it also includes unemployment benefits, sick pay, and some fringe benefits. Unearned income results from interest, dividends, royalties, and profits from the sale of assets—in other words, you didn't have to "go to work" to earn that money.

Paying as You Go

The IRS wants you to pay your taxes on an ongoing basis throughout the year. This is commonly referred to as "paying as you go."

Income taxes are taken out of employees' paychecks in a process called withholding, and their employers send the money to the government on the employee's behalf. This ensures that you've paid in a certain amount of tax by the end of the year.

The earnings of self-employed individuals aren't subject to withholding so they're expected to pay estimated taxes on their incomes four times a year. They must take an educated guess as to how much tax will be due on their income earned each quarter and send that money to the IRS in advance of filing their tax returns.

The estimating part can be tricky because penalties can result if withholding or estimated payments don't add up to at least 90% of the total tax they'll owe when they file their returns.

Tax Refunds vs. Owing the IRS

The government refunds any amount that employees or the self-employed overpay through withholding or estimated payments. Maybe you complete your tax return to realize that your total tax liability is $6,000. You paid in $6,500 through withholding over the course of the tax year. You'll receive a $500 tax refund from the IRS. You get that money back.

The flip side is that you'll owe the IRS $500 if your total tax liability is $7,000 and you only paid in $6,500. This balance must be paid by April 15 of the following year or the government will charge you interest and penalties on the amount outstanding.

A Progressive Tax System

The U.S. tax system is progressive. People who earn more money pay a higher percentage of it in taxes than those who make less money. Your tax rate changes depending on how much money you earn in a year.

Most states follow this system, but a handful have flat tax rates. They charge the same percentage to everyone, regardless of earnings.

The Progressive Tax System Debate

There's some debate over whether our tax rates should be progressive or flat. Politicians who support a flat tax argue that a single tax rate for everyone would greatly simplify the system and taxpayer's lives.

Politicians who support progressive tax rates argue that it's unfair to ask a person with only modest income to pay the same percentage as a wealthier person.

Tax Deductions

You can reduce your taxable income in a variety of ways. You might earn $50,000 for the year, but you won't necessarily have to pay taxes on $50,000 because the tax code is set up to allow for numerous tax deductions. Deductions are subtracted from your income so you pay taxes on less earnings.

For example, money you contribute to a retirement account such as a 401(k) or IRA plan isn't taxable, at least not yet.

You won't have to pay any tax on that money until you withdraw it from the plan. Contributions are made with pre-tax dollars—your employer will calculate the withholding on your paycheck on a lesser amount after contributions are subtracted and made. Alternatively, you can claim a tax deduction on your return for the amount you contribute.

The IRS limits how much you can contribute tax-free to these plans. The ceiling is $19,500 in 2020 unless you're age 50 or older. In this case, you get to contribute a little more to your retirement savings.

Tax Credits

The terms "credit" and "deduction" aren't synonymous. Deductions subtract from your income, while tax credits come off what you owe to the IRS.

You might have claimed all the deductions you qualify for, and you still owe the IRS $1,000 in taxes. But you won't owe the IRS anything if you also qualify for a $1,000 tax credit. The credit reduces or can even erase your tax debt.

Some credits are even refundable. You might owe the IRS $1,000 when you complete your tax return, but you have one qualifying child and you're eligible for an Earned Income Tax Credit in the amount of $3,584. That credit wipes out the $1,000 you owe and the IRS will send you a check for the balance. That's $2,584 in your pocket that you didn't have before.

The goal of tax planning is to choose which tax benefits make the most sense for you. People are free to arrange their financial affairs in such a way as to take advantage of these tax breaks. You can pay less in taxes by managing your finances in a way that minimizes the amount you owe.

Article Sources

  1. IRS. "Here’s How and When to Pay Estimated Taxes." Accessed Feb. 1, 2020.

  2. IRS. "Credits and Deductions for Individuals." Accessed Feb. 1, 2020.

  3. IRS. "Retirement Topics - Contributions." Accessed Feb. 1, 2020.