Do you know how your income tax is calculated?
As the April 15 Deadline looms again, this quick run-down of income taxes may help you to see the big picture. While the U.S. Tax Code is immense, complex, and often perplexing, it is possible to distill and digest the main components with a little effort.
The first component for income taxes is your Total Income. This includes all of your earned and unearned income, without any adjustments, exceptions, or deductions.
Minus Adjustments to Income
Next we get to subtract certain types of expenses. This is kind of like itemizing, except we're not itemizing. These are called "Above the Line Deductions".
- Educator Expenses (up to $250)
- Employee Business Expenses (Form 2160): E.g. transportation expenses (not commuting), overnight travel, and meals & entertainment
- Health Savings Account Contributions
- Moving Expenses (due to job or business)
- Self-Employed Deductions: E.g. self-employment tax, retirement contributions
- Student Loan Interest (up to $2,500)
- Tuition & Fees (Form 1098-T and Education Expenses)
Equals Adjusted Gross Income (AGI)
We now have our AGI, or Adjusted Gross Income.
Minus Standard or Itemized Deductions
Now we get to deductions. The two options are to take the Standard Deduction (i.e. no documentation required) or Itemize Deductions.
For 2015, the Standard Deduction is:
- $6,300 for single filers
- $12,600 for married filing jointly
- $9,250 for head of household (i.e. you have kids but no spouse)
If you've been keeping good records, you may be better off itemizing your deductions. These are the expenses you can add up to try and deduct more than the standard deduction from your AGI.
- charitable giving
- mortgage interest
- medical expenses (if over 10% of your AGI... this was previously 7.5%)
- state and local taxes: sales tax, income tax, real estate / property tax
- casualty & theft losses (if over 10% of AGI, e.g. hurricanes and floods)
Minus Personal Exemptions
The personal exemption amount for 2015 is $4,000 per person. This is essentially the amount of money each person would require to pay for basic food, shelter, and clothing. Understandably, we shouldn't be taxed on our income before we've been able to clothe, feed, and house ourselves and our dependents!
This is the line that parents with children really appreciate, especially those with newborns who arrived in December!
Equals Taxable Income
Now we arrive at Taxable Income, which is Total Income - Adjustments, Deductions, & Exemptions
Now we find out our Marginal Tax Bracket. This is the percentage of tax we pay on our last dollar of income. Here are the brackets for 2015:
2015 Marginal tax brackets
For the first $9,225 of taxable income, everyone pays 10% tax, or $922.50. Over that amount, you will pay 15% income tax on the amount between $9,226 & $37,450. It works like this through all of the brackets: 10, 15, 25, 33, 35, and 39.6%.
Note that you pay each bracket's rate for money earned in that bracket. So if you are in the highest tax bracket of 39.6%, you are only paying that percentage on every dollar above $413,200.
For this reason, your Average Tax Rate is lower than your Marginal Tax Rate.
Okay, so now we know how much we owe Uncle Sam. Thankfully, we can still reduce that amount with some tax credits. Tax Credits are different than Tax Deductions in that they reduce your actual tax liability dollar-for-dollar, whereas deductions reduce your taxable income. So Tax Credits are more powerful than deductions.
These tax credits are non-refundable, so they can reduce your tax liability to zero, but will not "make" you any money:
- Lifetime Learning Tax Credit
- Retirement Saver's Tax Credit
- Childcare & Dependent Care Expenses Tax Credit
These are refundable tax credits, meaning they can actually reduce your tax liability to zero and then give you a positive tax balance - meaning the government is paying you.
- Earned Income Credit
- Health Coverage Tax Credit
- Making Work Pay Tax Credit
- Additional Child Tax Credit (if you didn't qualify for the Childcare Expenses credit)
Plus Other Taxes
But wait, there's more. You may have to add additional money to your tax bill under certain circumstances.
- Self-Employment Tax
- AMT or Alternative Minimum Tax
- Tax on Premature Distributions
Equals Net Tax Liability
Finally, we know how much we owe - or how much we're owed. Apparently, up to 80% of filers receive a tax refund. And while that might feel nice to get back a lump sum to pay off debt, take a vacation, or invest, it has really been an interest-free loan that you have provided to the government.
Whether you hire an accountant or prepare your own taxes (with the help of software!), it's helpful to know the behind-the-scenes components of your tax liability or return.