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Taxes on Income

Taxes are a certainty. This page introduces several fundamental tax concepts.

 

Income taxes – individuals are required to pay taxes based on income.  Income tax is calculated as a percent of your income.  As income rises, the income tax rate generally increases -- according to tax law.

Income subject to income tax includes wages & salaries, profits earned from owning and operating a business, and dividends or interest earned from investments.  This list is not exhaustive.  Gifts and loans are NOT income for the purpose of income tax.

 

Tax rate – U.S. income tax is a progressive tax meaning the tax rate rises as one’s income increases.  Note the tax rates in the following tables (Tax Brackets for 2015).

Individual Taxpayers:  see Forbes

http://blogs-images.forbes.com/kellyphillipserb/files/2014/10/Single_rates.png

Married Individuals Filing Joint Returns and Surviving Spouses

http://blogs-images.forbes.com/kellyphillipserb/files/2014/10/MFJ1.png

Taxpayers are categorized according to their situation.  The tables above illustrate two categories of taxpayers; married filing separately and head of household are two other categories of taxpayers.

 

Federal Insurance Contributions Act taxes (FICA taxes), also known as Social Security Tax and Medicare Tax – a tax paid to fund the social security program which pays benefits to disabled persons, family survivors of deceased works, retired persons and others.  The employer pays half of this tax and the employee pays half of this tax.  Social Security tax rate is 12.4% of the employee’s wages or salary; the Medicare Tax rate is 2.9%.  Thus, the total tax rate is 15.3% or 7.65% of the employee’s wages for both the employer and employee.  The maximum amount of earned income subject to Social Security FICA tax in a year’s time is $118,500.  There is no “maximum amount” for Medicare FICA tax.

Federal Insurance Contributions Act (FICA) tax is a federal payroll (or employment) tax imposed on both employees and employers to fund Social Security and Medicare - federal programs that provide benefits for retirees, the disabled, and children of deceased workers. 

 

Taxable income – not all income is subject to income tax; consequently, persons with low income pay little or no income tax.  The standard deduction and personal exemptions are amounts of income that are not subject to income tax.

 

Do not forsake income because it is subject to income tax.  The tax rate is always less than 100%, thus income, even if subject to income tax, will leave more “money in your pocket,” than you would have if you did not accept the income.

 

Standard Deduction – an amount not subject to income tax based on the family unit.  An alternative to using the standard deduction is to itemize your deductions on Schedule A.  Expenditures that can be itemized include 1) medical & dental expenses, 2) taxes paid, 3) interest paid, 4) charitable gifts/donations, 5) casualty losses, and 6) some employment expenses.  Taxpayers will itemize or use the standard deduction, depending which one is greater.  Note – there are unique rules to determine the amount that can be deducted of each of the categories of deductions.

 

See line 40 on Form 1040, as well as Schedule A if you itemize your deductions.

 

Personal exemption – an amount not subject to income tax based on each person in the family; a couple with two children (dependents) would be entitled to four personal exemptions, for example. 

The personal exemption for 2014 is $3,950 and for 2015 is $4,000.

 

Do you or your parents claim the deduction for your personal exemption?

A dependent child must (1)(a) be under age 19 or (b) under age 24 and a student, (2) have lived with the parent for more than half of the year, (3) not have provided more than half of his or her own support for the year.

If these conditions are not met, the individual claims their own personal exemption; their parents can no longer claim the individual as a dependent.

 

Withholding – employers are required to work with employees to calculate approximate income taxes (W-2 form), and employers hold back that amount from the employee’s pay.  The employer then submits this amount to the government.  Withholding by employers is required by law to make it easier for the government to collect taxes from employees.

 

Filing income tax return -- At end of year, employee/taxpayer completes a tax return to determine how much the person should have paid in taxes.  If more was withheld than is owed, taxpayer is entitled to a refund; if amount that has been withheld during the year is less than amount owed, taxpayer has to pay the remaining tax obligation.  If taxpayer is entitled to a refund, taxpayer can decide to leave the money with the government as a prepayment of future taxes (this probably does not happen too often).

 

Taxpayers must pay estimated taxes quarterly if income taxes are not being withheld from their income; for example, business owners (except farmers) pay estimated on the business’ earnings.

 

Tax forms

  • W2 (information to employer so employer can decide how much to withhold),
  • W4 (document at end of year wherein employer reports to employee and government amount earned by employee and amount withheld by employer),
  • 1040 (tax form used by individuals to calculate taxes and amount of refund or payment), 1040A (alternative form for taxpayers to use if their transactions are fairly simple), 1040EZ (tax form used if taxpayer’s transaction are very simple, straight forward)  -- http://www.irs.gov/Forms-&-Pubs

 

Education credit – an amount available to reduce your taxes if you are going to college; do you claim the credit or do your parents (line 50 on Form 1040).  Also note a deduction for student loan interest on line 33 and tuition and fees on line 34.

“…you cannot claim the tuition and fees tax deduction in the same tax year you claim either the AOTC or the Lifetime Learning credit. You must choose between taking an education tax credit or taking the deduction for tuition and fees. Also, you can’t claim the tuition and fees tax deduction if anyone else claims an education credit for you in the same tax year. Although the credit usually results in a greater tax savings, calculate both the tax credit and the deduction on the tax return to see which is better...” from http://www.irs.gov/Individuals/Education-Credits:-Questions-and-Answers

 

Additional excerpts from web pages

  • Hope Scholarship Credit. The Hope Scholarship Credit for 2015 will be an amount equal to 100% of qualified tuition and related expenses not in excess of $2,000 plus 25% of those expenses in excess of $2,000 but not in excess of $4,000. That means that the maximum Hope Scholarship Credit allowable for 2015 is $2,500. Income restrictions do apply and for 2015, those kick in for taxpayers with modified adjusted gross income (MAGI) in excess of $80,000 ($160,000 for a joint return).
  • Lifetime Learning Credit. As with the Hope Scholarship Credit, income restrictions apply to the Lifetime Learning Credit. For 2015, those restrictions begin with taxpayers with modified adjusted gross income (MAGI) in excess of $55,000 ($110,000 for a joint return).
  • Student Loan Interest Deduction. For 2015, the maximum amount that you can take as a deduction for interest paid on student loans remains at $2,500. Phaseouts apply for taxpayers with modified adjusted gross income (MAGI) in excess of $65,000 ($130,000 for joint returns), and is completely phased out for taxpayers with modified adjusted gross income (MAGI) of $80,000 or more ($160,000 or more for joint returns).

 

 

Distinguish between a deduction and a credit – a deduction reduces taxable income; a credit reduces your taxes.  A $10 deduction reduces your taxable income by $10; if you are in a 30% tax bracket, the $10 deduction reduces your taxes by $3.  A $10 tax credit reduces your taxes by $10.  Bottom line – if the amount is equal, a credit always is preferred over a deduction.

 

Additional excerpts from web pages

  • Earned Income Tax Credit (EITC). For 2015, the maximum EITC amount available is $3,359 for taxpayers filing jointly with one child; $5,548 for two children; $6,242 for three or more children (up from $6,143 in 2014) and $503 for no children. Phaseouts are based on filing status and number of children and begin at $8,240 for single taxpayers with no children and $18,110 for single taxpayers with one or more children.
  • Child Tax Credit. For 2015, the value used to determine the amount of credit that may be refundable is $3,000 (the credit amount has not changed). Keep in mind that this is the value of the expenses used to determine the credit and not the actual amount of the credit.

 

 

This discussion has focused on U.S. federal income tax; be mindful that most states also impose an income tax and some large cities impost an income tax.  You are expected to file a state income tax return for each state in which you earned income during the year.

 

Other common taxes –

  • Sales tax – a state or local tax imposed on the amount you spend; not all items are subject to a sales tax.
  • Property tax – local tax imposed on the owner of property based on the value of the property; generally apply to real property (as opposed to personal property).

 

 

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