Understanding Income Tax Laws
Tax forms can be pretty scary. And sometimes your favorite tax software doesn't make things easier. Fortunately, there are some very basic ideas which can help you understand what taxes are all about.
Why do we have taxes at all?
The United States has a big budget. We have to pay for things like schools, roads, hospitals, the military, government employees, national parks, and so forth. The only way to pay for these things is for the government to get money from people and companies. People and companies pay a percentage of their income to the government. This is called the income tax. The government taxes our income so it can have enough money to pay for the things we all need.
Congress and the President of the United States are responsible for writing and for approving the tax laws. The Internal Revenue Service is responsible for enforcing the tax law, for collecting taxes, for processing tax returns, for issuing tax refunds, and for turning over the money collected to the US Treasury. The Treasury, in turn, is responsible for paying various government expenses. Congress and the President are also responsible for the federal budget. The budget is how much the government plans to spend on various programs and services.
When the government spends more money, it must raise more money through taxes. When the government spends less money, it can afford to lower taxes.
Five Aspects of the Tax System
Everyone is subject to taxation. The amount of taxes you owe is based on your income. You must pay taxes throughout the year on a pay-as-you-go system. People who earn more income have higher tax rates than those who earn less, this means tax rates get progressively higher the more you earn. You can reduce your taxes by taking advantage of various tax benefits. Finally, it's up to you to take control of your tax situation. Let's look at each of these five aspects of the tax system in more detail.
First of all, every person, organization, company, or non-profit is subject to the income tax. "Subject to income tax" means that people and organizations must report their income and calculate their tax. Some organizations are exempt from tax. But they still have to file a return, and their tax-exempt status could be revoked if the organization fails to meet certain criteria.
Secondly, you are taxed on your income. That's the long and the short of it. Income is any money you earn because you worked for it or invested for it. Income includes wages, interest, dividends, profits on your investments, pensions you receive, and so forth. Income does not include gifts. You are not taxed on gifts you receive, such as inheritances and scholarships.
Thirdly, you must pay your taxes throughout the year. This is called "pay as you go." For most people, it means your income taxes are taken out of your paycheck and sent directly to the federal government. At the end of the year, you have paid in a certain amount of taxes. If you paid in more than what you owe, the government refunds the amount over what you owed. This is called a tax refund. If you haven't paid enough to cover what you owe, then you have a balance due. And you must pay this amount due by April 15th of the following year, or the government will charge you interest and penalties on the amount you haven't paid in.
Fourthly, the US tax system is progressive. That means that people who make more money have a higher tax rate, and people who make less money have a lower tax rate. Your tax rate will change depending on how much money you made that year. There is a debate over whether our tax rates should be progressive or flat. Politicians who support a flat tax argue that a single tax rate for everybody will greatly simplify people's lives. Politicians who support progressive tax rates argue that it is unfair to ask a person of modest income to pay the same percentage of their income as a wealthier person.
This idea of fairness is the motivation for all sorts of tax benefits. For example, you can reduce your total income if you contribute money to retirement account, such as a 401(k) or IRA plan. There are many other types of tax benefits. Tax benefits are how Congress rewards people for making certain types of decisions. The goal of tax planning is to choose which tax benefits make the most sense for you.
Finally, the income tax system is voluntary. That's because people are free to arrange their financial affairs in such a way to take advantage of any tax benefits. Voluntary does not mean that the tax laws don't apply to you. Voluntary means you can choose to pay less taxes by managing your finances in a way to minimize your taxes.