How Income Taxes Work – Even If You’re Not A Tax Person

There’s lots of misunderstanding about how income taxes work. There are literally thousands of pages of laws, and hundreds of different tax forms. However, the basic system isn’t really that complicated. Understanding the basics of how income taxes work is a key step in making sure that you get your taxes right. It also helps you make smart tax decisions when you have choices.

The Budget Billing Analogy

Before I explain the income tax system, let me explain something very similar: budget billing for utilities.

If you sign up for budget billing for your utilities, the company estimates your total utility cost for the year. They then divide that number into twelve months. You make that estimated payment each month, regardless of the amount of your actual utility bill. At the end of the year, the company calculates the amount of all your payments, and the amount of all your bills, and compares them.

If you’ve paid too much, you’ll get a refund of the overpayment. If you haven’t paid enough, you have to make up the difference.

(Slightly off topic, but research has shown that people on budget billing tend to spend slightly more on their total annual utility bill than their neighbors who pay for their utility usage based on actual usage each month. The theory is that there isn’t immediate feedback, so it’s easier to turn that heat up another degree or take a little bit longer shower.)

A Budget Billing Example

Let’s imagine we have two neighbors, Shawn and Terry. Both Shawn and Terry are signed up for budget billing with their electric company. The utility company estimates how much electricity they will use in a year based upon prior usage and other information about their properties. The company divides that total by 12 and sends that amount as the bill  each month. That money gets applied to their account. Then the company balances the account at the end of the year.

The utility company has done a good job of estimating Terry’s and Shawn’s electric usage for the year, but they’re off by a little bit in each case. That’s to be expected; the utility company has no idea about different variables. They don’t know that Terry has decided to be very careful about his usage, or that Shawn bought a huge new TV that uses a lot of electricity.

At the end of the year, each account is balanced by comparing the total charges to the total payments. Terry has overpaid, so he is receiving a refund. Shawn has underpaid, so he has an additional amount due.

I’ve made some graphics to explain this better:

Does that make sense so far? Good, because income taxes are calculated pretty much the same way.

Withholding and Taxes

Income taxes are calculated on a yearly basis, but no one knows how much you’ll owe at the end of the year. Therefore, your employer has to estimate your yearly income and any deductions and credits you might receive.

Withholding

Each time you are paid, the employer’s software or payroll company calculates your estimated yearly earnings by multiplying your earnings for this pay period by the total number of pay periods in the year.

Then, it calculates what your estimated annual tax liability will be, using your estimated annual income and the instructions you provided when you filled out your W-4 Employee’s Withholding Certificate. Note: many people fill out their W-4 online, and may not recognize it as their withholding instructions.

The, the payroll software divides the estimated amount of taxes by the number of pay periods in the year. The appropriate amount is withheld from your pay for federal income taxes. the employer forwards that money to the Internal Revenue Service (IRS) . The IRS holds that money, like a savings account, to be used to pay your tax bill at the end of the year.

Calculating Your Taxes

At the end of the year, you (or your tax preparer) add all your income from the year, subtract any adjustments to income,  and exemptions, to get your taxable income. Then, you calculate how much tax is owed on that taxable income. After that, you subtract any credits (such as the child tax credit), and add any additional taxes owed (such as self-employment tax), to get your total tax liability. Lastly, you compare the amounts you’ve had withheld from your pay throughout the year, and apply any refundable credits (like the earned income credit.) If you withheld too much, you get a refund. If you didn’t withhold enough, you’ll owe.

Just like with the electricity bill, you’re having estimated taxes taken out over the course of the year, in the form of withholding. This is the amount on your paycheck that says Federal Income Taxes. It’s not actually a tax payment, it is an estimated payment towards your total year’s bill.

At the end of the year, you calculate your taxes due. Then you compare the total amount you owe for the year to the amount that has been withheld. If you’ve overpaid, you get a refund. If you’ve underpaid, you owe additional tax.

About Tax Brackets

One area that really confuses people is how tax brackets work. Many people think that if their income increases, and pushes them into a higher tax bracket, they’ll pay a lot more taxes. That simply isn’t true. Our tax system is marginal, meaning that you only pay the higher taxes on the income that falls into that higher bracket.

Our country currently has 7 tax brackets, with different income levels for different filing statuses.

Any income in the lower bracket is only taxed at that lower rate. Only the higher income is taxed at the higher amount. So if you make $1 more in a higher tax bracket, only that $1 is taxed at the higher rate. The money in the lower tax bracket is taxed at the lower rate.

You Might Have Several Parts

While you only have one total tax bill for the year, it is made up of several parts. It is important to understand how the parts impact your total bill.

For example, you might have one W-2 income, and you might have a rental property, and you might have some 1099 income reported on a Schedule C. They all get lumped together in one total federal tax return, but the parts are important, too, for planning and understanding. For example, you might have a tax liability due to your W-2 income, but you might have a loss from your rental property, and you might owe a lot due to your self-employment (thanks to the Self-Employment Tax.)

Importantly, taxes may have been withheld, or not withheld, at various rates on various types of income. For example, W-2 income, like military pay, is having taxes withheld by the employer as we’ve described above. However, self-employment income and rental property won’t have any taxes withheld unless you’re making quarterly estimated payments. Lastly, bonuses are withheld at the 22% tax rate regardless of your regular tax rate.

If you only look at the bottom line, you don’t really know how much each part is costing you. I’ve found this to be particularly true of self-employment income. Folks tell me, “I’m not paying taxes on my self-employment because we got a tax refund.” What they’re not seeing is that they might have a much larger refund without self-employment income. This is only an example – it can work out all different kinds of ways – but that’s a common one.

I hope this makes it a little easier to understand how income taxes work. If you have questions, please ask in the comments.  I’ll answer them AND make this piece better.