Understanding Income Tax Laws

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Tax forms can be intimidating, and tax software does not necessarily make them less so. Fortunately, there are some tax principles and fundamentals that can help you understand what taxes are all about.

Why Have Taxes at All?

The United States has a big budget. Infrastructure such as schools, roads, hospitals, the military, government employee wages, and national parks eat up substantial resources. The only way to raise the financial resources required to pay for social needs is to tax individuals and companies. Individuals and companies pay a percentage of their income to the government. This is called income tax.

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 U.S. 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 or increase the deficit, the money that the country has borrowed to pay for programs and services.

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, which means that tax rates get progressively higher the more you earn. You can reduce your taxes by taking advantage of various tax benefits. Finally, it is 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 nonprofit is subject to 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.

Second, you are taxed on your income. Income is any money you earn because you worked for it or because you invested resources and received a return. An investment could be buying stock or buying a property from which you earn rental income. Income includes wages, interest, dividends, profits on your investments, and pensions you receive. Income does not include gifts. You are not taxed on gifts you receive such as inheritances and scholarships.

Third, you must pay your taxes throughout the year. This method of paying taxes is called "pay as you go." For most people, income taxes are taken out of their paycheck and sent directly to the federal government. At the end of the year, you have paid a certain amount of tax. If you paid more than you owe, the government refunds the amount you owe. This is called a tax refund. If you have not paid enough to cover what you owe, then you have a balance due. 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.

Fourth, the U.S. 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 a retirement account such as a 401(k) or IRA plan. There are many other types of tax benefits. Tax benefits are a way for Congress to reward people for making certain 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 do not apply to you. Rather, voluntary means you can choose to pay less taxes by managing your finances in a way that minimizes the amount you owe.