Here’s a very handy, succinct, and clear overview of how to pay federal income taxes, explaining the key concepts. The author explains the difference between the various definitions of income:
The first step in calculating your income tax liability is to calculate your income. You add up all your wages, tips, short-term investment income, business and rental profits, etc, and you subtract out your personal exemption; business, rental, and investment losses; contributions to tax-deferred retirement accounts; etc. The number you come up with at the end of this process is your Adjusted Gross Income (AGI). There’s also several numbers called Modified Adjusted Gross Income (MAGI) which you may have to calculate later on to figure out if you’re eligable for deductions and credits which phase out when your income is too high; there are four or five different MAGI, each with its own formula, where you add back in certain things you subtracted out of your AGI.
Next, you calculate your Taxable Income. You have a choice here: you can either add up all the Itemized Deductions you’re eligable for (the big ones for most people are state taxes, mortgage interest, and charitable contributions), or you take the Standard Deduction which is a flat dollar amount based on the number of people in your household. Usually, the standard deduction is higher unless you own a house with a mortgage or you have a large income in a state with high taxes. Whichever number you chose, you subtract from your AGI to yield your taxable income.
This is really helpful information, especially to people who are filing for the first time on their own or who just want to make sense of the final document by their tax preparer.
The author also describes in detail the three types of tax breaks – “above the line” deductions, “below the line” deductions, and “tax credits” – with a digression on how the latter is modified by Income Phase Outs. He also suggests three useful metrics that everyone should calculate (or ask their preparer to calculate for them) to get an clearer idea of how much of a tax burden they really have:
Your Average Tax Rate is simply your total tax liability (taxes owed minus tax credits) divided by your income. You can use your AGI for this for simplicity’s sake, but if your AGI is at all complicated I’d suggest calculating your actual income from a personal finance perspective rather than a tax-law perspective (i.e. what you’d tell the bank your income was if you were applying for a loan).
Your Tax Bracket is how much your taxes owed changes when you raise or lower your taxable income by a small amount. If you itemize deductions, this represents how much an additional dollar of below-the-line deductions is worth to you. You can find this by taking your taxable income and looking up where it falls on the tax bracket table.
Your Effective Marginal Tax Rate is how much your taxes owed changes when you raise or lower your AGI by a small amount. This represents how much an additional dollar of above-the-line deductions is worth to you, and how much of a bite was taken from your last dollar of income.
(You should repeat these calculations for state taxes and payroll tax as well)
It’s a great article and well worth reading in full! One week to go…