Understanding Income Tax Laws

A smiling taxpayer reviews his tax return

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Tax laws can be complicated, and tax software doesn't necessarily make them less so. Fortunately, some fundamental rules and principles can help you understand what taxes are all about and the rules associated with them, from the types of taxes you must pay to being able to exempt certain income from taxation.

The Purpose of Taxation

The United States has a big budget. Maintaining roads, the military, and government employee wages and pensions eats up substantial resources. Taxing individuals and businesses is one of the only ways the country can raise the financial resources to pay for these social and civic needs.

Individuals and businesses pay a percentage of their earnings to federal and state (and sometimes local) 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 then enforces these laws, collecting taxes, processing tax returns, issuing tax refunds, and turning the money collected over to the U.S. Treasury, which is responsible for paying government expenses.

Congress and the president are also responsible for establishing a federal budget. The government must raise more money through taxation, or increase the national deficit when the government spends too much. The national deficit is created when the country has to borrow to pay for programs and services.

Almost Everyone Is Taxed

Just about every person, organization, company, and estate is subject to the income tax if they have income. People and organizations must report their incomes on tax returns and calculate their taxes due.

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

Individuals are exempt from filing tax returns if they earn less than certain limits that are adjusted annually for inflation.

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.

The Tax System Is Progressive

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 is based on increments of your income.

For example, you'd pay just 10% in federal taxes on your 2020 income up to $9,875 if you're single. You'd then pay 12% on your income from $9,876 up to $40,125. The highest tax rate is 37% on 2020 incomes over $518,400 for single taxpayers. This is the income you'd report on the tax return you'd file in 2021.

Most states follow this system (and some have none at all), 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 taxpayers' 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 of their earnings as a wealthier person.

Types of Taxable Income

Income is divided into two categories: earned and unearned. Earned income is anything generated from working for an employer, and it also includes unemployment benefits, sick pay, some fringe benefits, and income derived from self-employment. 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.

Income includes:

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

Income doesn't include gifts or inheritances, at least not at the federal level.

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 that money to the government on the employee's behalf. This ensures that they've paid in a certain amount of tax by the end of the year.

Self-employed individuals aren't subject to withholding on their earnings, 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 the income they've 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 payments don't add up to at least 90% of the total tax you'll owe when you file your return.

Tax Refunds vs. Owing the IRS

The government refunds any amount that taxpayers overpay through withholding or by making estimated payments. You might complete your tax return and then realize that your total tax liability is $6,000. If you paid in $6,500 through withholding over the course of the tax year, you'll receive a $500 tax refund from the IRS.

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

For 2020 individual tax returns, the IRS has extended the filing deadline from the usual April 15 to May 17, 2021. This does not apply to estimated tax payments, which were still due April 15.

Tax Deductions

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 lower earnings.

For example, money you contribute to a retirement account such as a 401(k) or IRA plan isn't taxable in the year you make the contribution. You won't have to pay any tax on that money until you withdraw it from the retirement plan. Your employer will calculate withholding from your paycheck on a lesser amount after your contributions are subtracted, or 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 $6,000 in 2020 unless you're age 50 or older. In this case, you can contribute $1,000 more.

Tax Credits

Tax credits and deductions are two separate things. Deductions subtract from your income, and you're taxed on the balance, while tax credits come off what you owe to the IRS.

You might have claimed all the deductions you qualify for, and 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 refundable. You might owe the IRS $1,000 when you complete your tax return, but maybe you're eligible for a tax credit in the amount of $2,000. That credit would wipe out the $1,000 you owe, and the IRS would send you a check for the balance. That's $1,000 in your pocket that you didn't have before.

The Bottom Line

The goal of tax planning is to choose which tax benefits make the most sense for you. You are free to arrange your 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.