How do taxes work

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The Basics

When you start a new job, you begin by filling out a W-4. This form asks you to list withholdings, such as dependents. From this, your payroll department will estimate the amount of income tax that should be withheld from your paycheck to pay federal and state income taxes. Income taxes are a percentage of the total paycheck that is paid back to the federal and state governments. The percent of tax that is applied to your paycheck depends on the tax bracket you fall in. Currently, the IRS has six tax brackets, based on amount of income. These range from 10 percent for the lowest-paid workers to 35 percent for the wealthy. State percentages are lower.

The Math

Calculating income tax is a complicated process because you do not pay your taxes on your gross incomes. Instead, it is the taxable income. To find the taxable income, take your gross income and subtract any adjustments you might have. Adjustments include things like alimony, retirement plan contributions, self-employment tax, moving expenses and a few other items. This gives the adjusted gross income. From this number, any applicable deductions and personal exemptions are subtracted. Deductions are things like charitable contributions and medical expenses. Personal exemptions include deductions for you, your spouse and any dependent children. This gives the taxable income. This taxable income is multiplied by the tax rate to give the gross tax liability. However, this is not yet the amount of tax that needs to be paid. Some taxpayers have credits, such as the cost of childcare, that are subtracted from the gross tax liability. Once these are subtracted, your net tax bill remains.

The Reality

This is quite a complicated process, and the payroll department at a typical company does not have the ability to calculate all of the deductions you may qualify to claim. The company will estimate the amount of

tax that should be withheld based on the information on your W-4. However, sometimes too much or too little will be withheld. This is why you must file your tax return every year. Some deductions that would not have been figured into the payroll can lower the tax bill, which means you will deserve a refund. For instance, if you had many medical bills over the course of the year, the payroll department will not adjust your paycheck withholdings because of this deductible expense. However, you can enter this expense in your tax return and receive a refund for the amount you should not have paid. Similarly, if too little tax was withheld, which can happen if you claim too many personal deductions on the W-4, you will have to pay the difference by April 15.



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Category: Taxes

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