What Are Income Taxes?

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. 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. Americans then 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 into 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. However, 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

The federal income tax wasn’t always a fixture of American life. During the Civil War, Abraham Lincoln introduced an early version of the income tax to help finance the war effort, but it was repealed in 1872. In 1894, a new income tax was introduced, but the following year, the Supreme Court deemed it unconstitutional because it was a direct tax not apportioned among the states based on population.

In 1909, President Taft proposed a constitutional amendment to grant the federal government authority to levy a direct income tax without distributing the burden among the states according to population. After several years of debate, the 16th Amendment was ratified in 1913, giving birth to the first Form 1040.

The Revenue Act of 1918 introduced a progressive income tax structure, with rates climbing as high as 77%. That’s right — 77%. Since its inception, the federal income tax has been a persistent source of political debate — and plenty of frustration for taxpayers.

Taxable Income

There’s taxable income and there’s non-taxable income. Non-taxable income includes child support payments, life insurance proceeds received after the policyholder dies, cash rebates and welfare benefits. Your Social Security income may or may 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. 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.

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