Chapter 4 – The Income Tax System

In this chapter, we are going to discuss the nature and role of income taxes.

The Progressive Tax System

The United States uses a type of income tax system called a progressive income tax system. Progressive income tax systems are designed to charge progressively higher taxes to people as their income rises. In other words, the more income you earn, the more taxes you pay. That's how the system is designed.

Federal taxes in the United States are administered and collected by the Internal Revenue Service (IRS). The IRS taxes income in groups, or brackets. These tax brackets determine how much taxes are owed on the money in that bracket. Each dollar you earn is taxed just once. When we calculate how much income tax you have to pay, we assign each dollar to a tax bracket, starting with the brackets with the lowest tax rates and moving up. How much taxes you pay on each dollar depends on which tax bracket that dollar is assigned to.

This means that some of your money is not taxed at all. Some of your income is taxed at a very low rate. People with high incomes will have portions of their income taxed at a high rate. The more money you earn, the more you will pay in taxes. If you have low income, you will pay little or no taxes.

You can see exactly how the progressive tax system and tax brackets work in Math Skill 3 of the workbook!

Tax evasion is avoiding paying taxes that you are legally required to pay. Tax evasion is a very serious crime, and one which you should never consider doing. Tax evasion usually occurs when a person lies about or hides their income from the IRS.

Tax avoidance is different from tax evasion. Tax avoidance is seeking legal ways to reduce, eliminate, or defer income taxes. In other words, tax avoidance involves the using the tax code to avoid paying taxes that you are not legally obligated to pay. To engage in legal tax avoidance, you should claim all deductions and credits that the IRS has said you can claim. This is best done with the help of sophisticated tax filing software or by hiring a tax expert to help you identify all the possible ways you can legally reduce your taxes.

Research shows that hiring a professional tax accountant often saves you more money than you pay them for their services!

Tax Refunds

You may have noticed that every paycheck you get has some money taken out for taxes. These automatic tax collections are called withholdings. We calculate your withholdings when you fill out a form W4. This form will be given to you by your employer when you start a new job. The number of allowances you select on this document is used to estimate how much you will owe in taxes for the year. This estimate determines how much taxes are withheld from each paycheck. These withholdings are used to pay your taxes each tax season.

We report our income to the IRS each year during tax season and calculate the exact amount of taxes owed for the year. We then compare the amount we have already paid (through witholdings) to the actual amount that we owe. Remember that the amount withheld from your check is just a guess about how much taxes you might owe. That guess is usually close to the actual amount of taxes owed but it is rarely perfectly accurate. You will get a tax refund if you have paid too much in taxes over the year. We call this over-withholding.

People get very excited to get a tax refund. It feels like they are getting free money in the mail. Tax refunds get far less exciting when you understand their true nature. A tax refund is exactly what it says it is: it is a refund of excess taxes paid. Getting a refund means you paid to much taxes and now the IRS has to give you some of your money back. The IRS does not pay interest on overpaid taxes. This means that over-withholding on your taxes allows the IRS to keep your money for free. The time value of money tells us that we want a reward if we have to give up our money. A large refund, therefore, is literally just giving the IRS a free loan. In a perfect world, the best tax refund is a $0 refund. This is very difficult to do in real life. Usually the best we can do is a arrange a very small refund. A small refund means that you accurately estimated your taxes. It allows you to have your money earlier. You don't have to wait for tax season to get your money back.

Filing Taxes

Your gross income is all the money you have earned from all sources. The first step in filing our taxes is to add up all your income to find your gross income.

Not all of your income is taxed. Taxable income is the portion of your income that is subject to tax. Taxable income will always be less than gross income. This allows families to have a portion of their income completely free from taxes. This gives families a certain amount of money that they can use to survive before they have to worry about taxes. It helps low income families pay fewer taxes and have more money to pay their own bills.

We find taxable income by subtracting deductions and adjustments from our income. Deductions are expenses which allow you to reduce your taxes. The money you use to pay for a deductible expense is subtracted from your gross income. For example, if you deposited $1,000 into a retirement account, your taxable income would be $1,000 less than your taxable income because of this deduction.

Deductible expenses can change from year to year, but medical expenses, other taxes you’ve paid, the interest paid on your home mortgage, gifts given to charity, and expenses incurred by your job are the most commonly used deductible expenses. Deductible expenses are often called “write-offs”.

There are thousands of deductions available. Hire a professional or use software to make sure you identify all the deductions that you are eligible to claim.

Every household has the option to either itemize their deductions, or to take a standard deduction. Itemized deductions require you to list (or "itemize") all the expenses you have that qualify for a deduction. This generally also requires you to provide receipts for these purchases.

If your prefer not to itemize your deductions, or you do not have very many deductions, then you should simply take the standard tax deduction. Anyone can claim the standard deduction for any reason. You don't have to provide receipts or prove your expenses. You simply check the box for standard deduction and you get the full amount of the deduction..

Your deductions are all subtracted from your gross income to provide your adjusted gross income, or AGI for short. Your AGI is the amount of money that is subject to income tax. It is your taxable income.

Your taxable income is the number you use in math skill 3 to calculate your total tax liability.

Your tax liability is the total number of dollars you must pay in income tax. The steps for calculating your tax liability is discussed in math skill 3.

Your final chance to reduce the amount of taxes you owe is by applying tax credits. Tax credits are subtracted from your tax liability. This is different from a deduction. A deduction is subtracted from your income and reduces how much income is taxed. It reduces how much you pay in taxes indirectly. A credit reduces how much you pay in taxes directly. If you have a $1,000 tax credit, you will always pay $1,000 less in taxes.

There are many tax credits and they can change from year to year, but some of the most commonly used credits include the hope scholarship credit, the lifetime income credit, the earned income credit, and the child tax credit. Be sure to check for new or updated tax credits every year when you file your taxes. The more tax credits you can claim, the less you will pay in income taxes!

Definitions:

Tax avoidance: seeking legal ways to reduce, eliminate or defer income taxes

Tax evasion: avoiding paying taxes that you are legally required to pay

Withholdings: automatic collections take out of your paycheck that are put towards federal and state income taxes

Over-withholding: when withholdings surpass your tax liability, a common occurrence for many taxpayers

Exclusions: payments which are not considered by the government to be taxable, such as gifts, inheritances, tuition and fees, child support payments and many other things

Taxable income: the total amount of income which you are required to pay taxes on

Tax liability: the amount of income taxes derived from your taxable income

Deduction: an expense that is allowed to reduce your taxable income. Also known as a “write- off”