This post is part of the textbook personal finance series which covers basic personal finance skills by going through an actual textbook, chapter-by-chapter. Check out the intro post for more information.

In the last month and a half, we were looking at the very basics of personal finance and money management. Now we’ve moved on chapter 3 and a very timely topic—taxes. There are many types of taxes: taxes on property, taxes on purchases, taxes on wealth, and taxes on earnings. Today we’re going to look at the last kind of taxes, specifically the basics of federal income taxation.

Once again, let me state that I’m working through a textbook and offering information about taxes but not professional tax advice or information.

Step 1. Determining Adjusted Gross Income

Determining your adjusted gross income (AGI) is the first step to determining your, the amount of income on which income tax is computed. Your AGI is your gross income after you’ve madde certain adjustments and exclusions. Most, but not all, income is taxable. Your gross (total) income is formed by any of these three components:

  1. Earned income — wages, salary, commissions, fees, tips, and/or bonuses.
  2. Investment income/portfolio income — dividends, interest, etc, from investments.
  3. Passive income — similar to investment income but comes from things in which you no longer actively participate.

There are other types of income which are subject to federal income tax, including alimony, lottery winnings, and prizes (game shows to blog contests). Under certain circumstances, you’re allowed to exclude amounts from your gross income. The first $80,000 earned while living and working in another country is excluded or tax-exempt income. This is different from tax-deferred income, which will be taxed at a later date (like earnings on regular IRAs).

Adjustments to the income include contributions to certain retirement plans (traditional IRA, Keogh), penalties for early withdrawal of savings, and alimony. This is not the time to take out deductions. You’ll deduct once you’ve calculated your AGI.

Step 2. Computing Taxable Income

Your taxable income is your AGI minus all tax deductions for which you’re eligible. I’ve already written a great deal about tax deductions, so I’ll move quickly past that and refer you to the article instead.

Be sure to keep records of any deductions you take, for at least three years. Ideally, you should keep them for seven, along with the returns.

The book notes that exemptions are deductions from gross income for yourself, your spouse, and qualified dependents. If you’re providing more than half of a dependent’s support and the dependent resides in your home for at least half of the year or is a certain kind of relative (child or stepchild, foster child, sibling or step-sibling, or descendants of any of these, such as your grandchild), you may be able to claim an exemption for them on your taxes. For tax years 2009 and 2010, the exemption is $3,650 per person.

The rules on proving that you provide more than half of a child’s support have changed in the last few years (since the textbook was written), but if the child (up to 19 or up to 24 if a full-time student) provides more than half of his or her own support then you cannot claim them as a dependent.

Step 3. Calculating Taxes Owed

The US tax system uses what are referred to as marginal tax rates (most of the time). These rates “are used to calculate tax on the last (and next) dollar of taxable income.” Not quite clear? Here’s how to think of it. If you’re in the 35% tax bracket, you don’t actually pay taxes on 35% of your income. The example below uses married, filing jointly tax rates.

Everyone pays 10% in taxes on the income between $0 and $16,700. If you made more than $16,700, then on the money between between $16,700 and $67,900 you’ll pay 15% in taxes.

So suppose that Micah and I have an AGI that comes to a nice, even $40,000 (because it makes math prettier). We would pay 10% of the first $16,700, or $1,670. Then we would subtract $16,700 from $40,000 and calculate 15% of that (because we already calculated taxes on the first $16,700). $40,000 – $16,700 = $23,300 and 15% of that is $3,495. $3,495 + $1,670 is $5,165, our total tax bill. That’s $900 less owed in taxes than if we paid 15% of our AGI as a flat tax.

In the previous section, we took off tax deductions. After calculating your taxes owed on your AGI, you get to apply tax credits. Tax credits are subtracted directly from the amount of tax you owe. Essentially, the government is saying “we’re going to credit this to your account like you already paid us.”

We get a tax credit for part of the tuition we pay for Micah’s continued enrollment as he teaches and finishes his dissertation. It’s my favorite part of doing taxes.

Step 4. Making Tax Payments

Even though we calculate and turn in taxes once a year, we actually pay taxes throughout the year. This is called withholding and it’s a pay-as-you-go system which keeps people from having to come up with thousands of dollars once a year. So even if you calculate that you owe $6,000 in taxes, you may have paid it all up front through withholding or may even receive a refund.

The W-4 you fill out when starting a job tells your employer how much you want withheld each month. Your employer will base it on your salary and filing status, but you can also have additional amounts withheld. Not having enough withheld can cause you to owe penalties.

If you’re self-employed or make a good deal of money from someone other than an employer, you may need to make estimated payments in order not to owe penalties at the end of the year and not to have to come up with all the money at once. Estimated payments are made at four points through a year, April 15, June 15, September 15, and January 15 (for the previous tax year).

Fortunately, if you under-withhold, you may fall under safe harbor, meaning you won’t get penalized, at least the first year. You’re given a chance to learn & adjust your withholding/make estimated payments better the next year.

Step 5. Watch the Deadlines

In most cases, you’re required to file your taxes on or by April 15. You can file an extension in order to get your documents in up to four months late, but you must still file an estimated payment by April 15th.

If you pay late or have too little withheld, the penalty you’re most likely to receive is based on interest since the time it was owed. Fortunately, if the IRS neglects to refund you the proper amount (or you don’t file right) and you claim a refund late, the IRS will pay you interest on the money.

Understanding vs. Doing Your Taxes

I was shocked to realize that for at least 6 years, I did my taxes by hand with a pen. Sometimes I would have to reprint the forms and try again because I’d made a mistake. I love the simplicity and ease of entering it all into a program, not having to find the right table for my taxes owed, not having to worry about lines, etc. When I was in my teens, it was easy. But now there’s a lot more going on.

Even so, I found this section immensely helpful the first time I went through the book. It helped me understand some of the whys behind taxes and how things actually work, even though I knew how to go through the mechanics. I think it’s very important to know, even if you’re using tax software.

{ 5 comments… read them below or add one }

Mrs. Micah's Mom March 12, 2010 at 4:09 pm

I always have more than the minimum taken out of my parttime earnings because I make so much less than your Dad.
Mrs. Micah’s Mom

Keith Morris March 15, 2010 at 9:30 am

I made a small tax blunder this year. I had saved money to pay the taxes that I knew I was going to owe due to several months of self-employment. When I started entering my forms into TurboTax, it was becoming apparent that I had saved more than I was going to owe. We were waiting for one final 1099 to come in when my wife decided she’d had enough of her computer crashing. I estimated the impact of the 1099 on our taxes, and we spent the extra money we had saved on new computers. When the 1099 finally came, my estimations were off, and we were $1,000 short. Luckily I had enough money in other accounts to pay for it.

Mrs. Micah March 15, 2010 at 9:38 am

@Keith OUCH! Glad you had the money elsewhere.

Keith Morris March 15, 2010 at 9:55 am

@Mrs. Micah Me too! 🙂

Personal Finance Advisers June 14, 2010 at 3:52 pm

I had saved more than I was going to owe. I thought I was going to owe self-employment due to several months. TurboTax forms entering into when I started mine, it was becoming obvious that.

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