Understanding How Income Taxes Work

Paying federal income tax now seems so routine that it’s hard to imagine a time when it didn’t exist. However, it is a necessity in life, and filing late or incorrectly – or not even at all – can have severe consequences. This is what you need to know about income taxes before tax time comes.

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 for 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 from your paychecks for tax payments. When you start a job, you fill out 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. This means that people with more money pay a higher proportion of taxes. The IRS has tax brackets that are tied to income. The more you make, the higher your tax bracket and the higher 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 because federal income taxes are marginal. That means your income is taxed based on the marginal tax bracket for your income level.

It can be daunting to file your federal income taxes correctly, but help is out there. You can use the Smart Asset Income Tax Calculator, along with interactive software, such as TurboTax or H&R Block, to demystify the process.

If you plan on applying for financial aid for college, you will need your income tax returns to complete the Free Application for Federal Student Aid (FAFSA).

Brief History of U.S. Federal Income Taxes

Federal income tax wasn’t always a fixture of American life.

During the Civil War, Abraham Lincoln introduced income tax as a way to help finance the war effort, but it was repealed in 1872.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 granting the federal government authority to levy a direct income tax that was not based on state 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%.

Indeed, 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 both taxable income and 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 retirement income and where you live.

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 accounts for the fact that you haven’t had an employer withholding income taxes for you. You must also pay Social Security and Medicare taxes yourself without an employer chipping in and withholding some of your wages to cover the tax bill.

When you work for someone else, you split the burden of Social Security and Medicare taxes with your employer. However, when 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 a tax liability of $1,000 or more, you should pay estimated tax over the year via Form 1040-ES. It may sound like a pain, but it will save you from one giant bill come April.

Deductions, Credits and Adjustments to Income

Federal income tax was not always a part of American life.

After income is calculated, certain provisions in the tax code change how much is subject to federal tax. Some of these provisions apply before adjusted gross income (AGI) is calculated and affect the income figure used throughout the return. These rules explain why reported income and taxable income are rarely the same number.

Taxpayers then account for deductions that reduce the income subject to tax. One option is a flat deduction set each year by the IRS, while the other reflects qualifying expenses paid during the year. Only one approach applies, and the selection changes the amount of income used to calculate tax.

Tax credits work differently from tax deductions because they apply directly to the tax bill itself. Some credits reduce taxes owed but cannot produce a refund, while others may result in a refund even when no tax is due. These rules influence both the final tax amount and whether a refund is issued.

Taken together, these adjustments shape the final outcome of a tax return. They help explain differences in tax bills among filers with similar earnings and show how tax liability is calculated step by step rather than as a single percentage applied to income.

Bottom Line

If filling out your tax returns has you scratching your head, consider enlisting the services of an accountant or some tax preparation software.

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 tax preparation software. If you’re lucky enough to get a tax refund at the end of the process, make a financial 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 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.