Understanding How Income Taxes Work

Paying a federal income tax now seems so routine that it’s hard to imagine a time when income taxes were controversial. The federal income tax as we know it is actually only a little over one hundred years old. That’s a whole lot of money. Let’s break down how income taxes work but you might want to find help with any personalized questions. A financial advisor can help you optimize a tax strategy for your financial needs and goals.

How Do Income Taxes Work?

Every spring, employers file W-2 forms on behalf of their employees and Americans fill out federal income tax returns on forms with opaque names like 1040 and 1099. Tax “returns” are the forms you submit to the IRS that determine your tax liability. If you’re an employee, your employer withholds some income tax payments from your paychecks. When you start a job you use IRS form W-4 to indicate how your employer should withhold taxes from your pay.

The federal income tax system in this country is progressive. “Progressive” in tax lingo means that people with more money pay a higher proportion in taxes. The IRS has tax brackets tied to income. The more you make, the higher your tax bracket and the greater the percentage of your income that’s taxed. Folks with very low incomes or no income don’t pay federal income taxes at all.

You don’t take your tax bracket and apply that percentage to your entire income, though. That’s because federal income taxes are “marginal.” When people refer to their tax bracket they’re actually referring to the top marginal tax bracket in which they fall. If you qualify in the first bracket your income is taxed at that rate up to a certain income threshold. If you have income over and above what would put you in the first bracket, that extra income is taxed at the second marginal tax bracket’s rate, and so on.

Filing your federal income taxes correctly can be daunting, but income tax calculators and interactive software (like TurboTax or H&R Block) are demystifying the process. Planning on sending your kids to college? You’ll need to have your income tax returns handy to fill out the Free Application for Federal Student Aid (FAFSA).

Brief History of U.S. Federal Income Taxes

As mentioned, the federal income tax was not always a part of American life. Abraham Lincoln instituted a precursor to the income tax to help fund the war effort during the Civil War. That tax was repealed in 1872, though. 1894 saw the creation of a new income tax, but the Supreme Court ruled it unconstitutional in 1895 because the tax was direct and not apportioned to the states on the basis of population.

Then, in 1909, President Taft proposed a constitutional amendment that would give the federal government the power to levy a direct income tax without spreading the tax burden across the states according to population. It took until 1913, but the 16th Amendment was ratified and the first Form 1040 was born.

The Revenue Act of 1918 created a progressive income tax rate structure with rates as high as 77%. Seriously. Since the federal income tax came into being it has been a source of political controversy – and groans from taxpayers.

Taxable Income

There’s taxable income and there’s non-taxable income. What is non-taxable income, you ask? Child support payments, life insurance proceeds received after the policyholder dies, cash rebates and welfare benefits are all examples of non-taxable income. Your Social Security income may or not be taxed, depending on whether you have other income on the side and where you live. It should be clear that your taxable income can be pretty different from your actual income, depending on your circumstances. Taxable income forms the basis for your taxes owed.

If you’re self-employed your income tax situation is a little more complicated. Taxable income for the self-employed takes into account the fact that you haven’t had an employer withholding your income taxes for you. Plus, you have to pay Social Security and Medicare taxes yourself, without an employer chipping in and withholding some of your wages to cover the tax bill.

If you work for someone else you split the burden of Social Security and Medicare taxes with your employer. If you’re self-employed, you shoulder that burden all on your own. The good news is that you can claim a deduction for a portion of that tax burden. If you expect to pay taxes of $1,000 or more when you fill out your return you should pay estimated tax over the year via Form 1040-ES. It may sound like a pain but it will save you from getting one giant bill come April.

Bottom Line

Paying your income taxes isn’t exactly fun, but that money funds lots of important things that we all depend on. If filling out your tax returns has you scratching your head, consider enlisting the services of an accountant or some tax preparation software. If you’re lucky enough to get a tax refund at the end of the process, have a plan for what you’ll do with that money. Pay off old debts? Bulk up your emergency fund? Both are great options.

Tips for Surviving Tax Season

A financial advisor can help you minimize your income taxes and make smart choices for your financial goals down the road. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you don’t know whether you’re better off with the standard deduction versus itemized, you might want to read up on it and do some math. Educating yourself before the tax return deadline could help you save a significant amount of money.
Figure out whether you’ll be getting a refund or will owe the government money so you can plan your household budget accordingly. SmartAsset’s tax return calculator can help you figure this out.