Personal Income Tax Basics: Taxes 101
Tax season seems to come around more quickly than we expect, despite being the exact same time every year. For some of us, this might be the first time we’ve ever had to think about personal income tax basics, and we’re not even sure which parts we should be worried about. For others, we’ve survived numerous Aprils by simply doing what our accountant says or hoping that online tax software knows what it’s doing. We kinda-sorta know what’s going on, but we’d have a hard time explaining it if asked.
Rather than wait to panic in early April, let’s take a step back and walk through a brief overview of some personal income tax basics. If you want to keep a separate tab open in your browser with something very complicated pulled up in case someone walks by, I won’t be offended. I think you’d be surprised how many people don’t actually know much about the taxes they pay. Many of us simply try not to think about it (which is a horrible strategy, by the way).
There are plenty of reasons to complain about taxes, of course. You may not like the way they’re collected, how much you personally have to pay, and few of us are thrilled about how the government spends them. That’s all part of a discussion for another time, however. For now, we’re going to focus on what is rather than what could or should be. Fair enough?
What Taxes Do We Pay?
Our focus here is on personal income tax basics, but they're not the only taxes you pay throught the year...
- A variety of taxes are taken out of every paycheck by your employer before you even see it
- When you spend part of that paycheck buying stuff you need, you pay sales taxes on every dollar
- If you put some of that paycheck into savings and earn a little interest, you’ll pay taxes on that
- If you own a home or other property, you pay property taxes. This is generally part of your monthly payment, diverted into an escrow account until taxes come due each year, although some of you may simply pay out-of-pocket annually
- If you own a car, you either paid special taxes upfront at the time of purchase or they’re rolled into your car payment
It’s easy to start to feel a bit overwhelmed by how often we pay taxes, directly or indirectly. Personally, I’d rather try not to think about them at all, but that’s not a great strategy. Let’s just focus on one element of tax basics at a time and we’ll get through it together, shall we?
Personal Income Tax Basics: What Happened to My Paycheck?
Do you remember your first “real” job? How great it felt to calculate that hourly wage as you wiped down tables, loaded boxes, or whatever you were hired to do? Then, you got that first check, and… WHAT THE--?!?
The total amount you’ve earned – the starting number of what you’re being paid – is your “gross income.” That’s the big number somewhere near the top before all the codes and shorthand telling you what’s been taken out.
The amount you actually receive is your “net income.” That’s what you have left to spend as you see fit.
The stuff your employer takes out before you’re actually paid comes in two general varieties. “Withholding” refers to taxes for which you are responsible each paycheck. They are so named because your employer is required to “withhold” them – to keep them back from your pay – and send them to the government on your behalf. “Deductions” are additional amounts pulled out, often at your request, to pay for things like retirement savings, health insurance premiums, etc. (If it makes you feel any better, your employer’s tax basics are much more complicated than yours, especially when it comes to payroll.)
What Does My Employer “Withhold”?
Take a look at a recent pay stub (whether on paper or online). The first thing some of you will notice is that there are dozens of lines and columns and abbreviations and acronyms and numbers and it looks like you need an accounting degree to sort it all out. DON’T PANIC. If there’s something we don’t cover here that still looks important, reach out to payroll and politely ask them to explain it.
Your “gross pay” will be clearly indicated somewhere near the top. Under that, you’ll see itemizations of what’s been taken out. Sometimes you get two columns – what’s been taken out of THIS paycheck, and what’s been taken out Year-To-Date (YTD).
One of the larger numbers, if not THE largest number, will be for Social Security. You know this one. You pay in throughout your working life, then, if the system holds, you receive money back from the government to help with living expenses after you’ve retired. (It’s more complicated than that, but that’s the basic idea.)
If you don’t see anything labeled “Social Security,” it might be called OASDI (“Old Age, Survivors, and Disability Insurance”). Or, Social Security withholding is sometimes combined with the Medicare tax and labeled together as “FICA.” FICA stands for “Federal Insurance Contributions Act.” It’s what first established payroll deductions for Social Security back during the Great Depression. Medicare came later, but both are a sort of “insurance” for employees to which the federal government ensures we each regularly “contribute.”
Another subtraction from your gross pay is your Federal Income Tax (FIT). This is exactly what it sounds like – a tax on your income at the federal level. Keep in mind that Uncle Sam expects a piece of the action on all of your income, not just the parts you get a bi-monthly paycheck for. If you sell extensively on Ebay or other online markets, that’s income. If you work for your uncle on the side and he pays you in cash, that’s income. If you’re paid to deliver the commencement address at your university, win money on a game show, or score big in the neighborhood garage sale, that’s income.
Technically, you’re supposed to claim it all. I’m not going to tell you what to do, of course, but be aware this is a thing. (Remember Al Capone?) For now, though, your employer is handling the heavy lifting in regards to your FIT by taking it out of your paycheck before you even receive it.
Although we’re focusing primarily on tax basics at the federal level, most of us will also see state income taxes withheld on that same pay stub, and possibly city or county as well. It all depends on where you live and work. Some states have relatively high personal income tax rates; others have no personal income tax at all.
You'll see other deductions as well – health insurance, retirement plans, voluntary contributions to local charities, etc. Our concern at the moment is with personal income tax basics at the federal level. That’s the part that involves the I.R.S. and the stuff many people most worry about come April of each year.
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Historical Tax Basics: Do We Really Have To Pay Federal Income Taxes?
You’ve probably encountered claims by those opposed to the Federal Income Tax that the entire thing is unconstitutional, that we don’t really have to pay it, and demanding we “take a stand.” These folks are often quite agitated, dressed in extremely patriotic colors, and heavily-armed.
Again, I’m just here to inform you. Our focus overall is to enlighten, encourage, and share a few tax tips along the way. Let me try, then, to tackle this very complex and historically interesting question of whether or not you really have to pay your federal income taxes in the clearest terms possible:
YES. Yes, you do. Absolutely. There is ZERO doubt about this.
I hope I didn’t get too technical on you.
The federal income tax was first instituted in 1861 during the American Civil War. It eventually went away, but popped back up again in the late 19th century before being declared unconstitutional by the Supreme Court. Don’t get too excited, though, because the 16th Amendment, ratified in 1913, made it constitutional. That’s what Amendments do – they change stuff in the Constitution. That’s why they’re hard to pass. But this one did.
So, to reiterate, if you don’t like your taxes, or how they’re spent, or whatever, the solution is NOT to refuse to pay them. The solution is to educate yourself on the specifics and go vote.
Now, back to the sorts of tax basics, we started with – the kind based on facts and reality instead of conspiracy theories…
Personal Income Tax Basics: What Happens on April 15th?
Hopefully, nothing. You should have done your taxes well before then. But April 15th is the deadline for filing your taxes from the previous calendar year. (This varies for businesses, who sometimes operate by fiscal year.) If April 15th happens to land on the weekend or a holiday, the deadline is the following Monday.
By the time April 15th rolls around, you should have already scheduled an appointment to have your taxes done by a professional, chosen your preferred tax preparation software, or secured a Form 1040 and the accompanying instruction book. Doing your taxes can seem overwhelming, but the entire process is really about two basic things:
Figuring out how much you owe for the year in federal income tax.
Figuring out how much you’ve already paid (usually via employers withholding it) for that year.
If you’ve paid more than you owe, you get a refund. If you’ve paid less than you owe, you’ll need to pay the difference. If all is right with the universe, the two amounts will be pretty close to begin with, and you’ll either get a small refund or pay a small amount.
Aren’t Big Refunds A Good Thing?
Not really. All that means is that you’ve loaned the federal government your money for free throughout the year. Sure, it’s nice to get it back in a big chunk, but you could do that with a savings account and be earning interest while still having easy access to funds should you need them.
More importantly, that money you get back could have been paying a little extra on your credit card bills each month, or paying towards the principal of your mortgage loan or auto loan. It could have meant less debt because you’d have had more money to pay for things as you go. In short, it means you limited yourself throughout the year. Don’t worry, though – you can fix that for the coming year.
I’m not going to address whether or not owing the I.R.S. lots of money is a good thing or not. I mean, that’s not really even a question, is it?
Paperwork Tax Basics: Get Your W-4 Right
If you received a substantial refund or owed a substantial payment, you need to change your withholding. As it turns out, you have some control over that through a form called the W-4. You probably filled one of these out when you were first hired. Turns out you can ask your employer for another one of these or download it yourself from the IRS website and change your withholding any time.
Remember that stuff your employer takes out of your check we talked about above? Social Security and Medicare withholding is dictated by federal law; those percentages are fixed. Anything taken at the state or local level is a function of those levels of government as well. But FIT – those Federal Income Tax dollars being withheld? You chose those when you filled out your W-4. (This doesn’t mean you have control over how much you’re expected to pay in total each year, but it does mean you can decide how much comes out via withholding along the way.)
That’s essentially all a W-4 does. It tells your employer how much to take out of each check for your federal income taxes. Your boss doesn’t necessarily know if you’re married or not, how many kids you’re supporting, how much your spouse makes, what other income you might have, etc. Half that stuff they’re not even legally allowed to ask. But you know (hopefully). It’s that information that helps you decide what to claim.
Don’t worry if you’re not clear on the details. The part you turn in to your employer is about half a page, but there are detailed instructions and a worksheet to help you figure it out. Just go through it step-by-step and you’ll end up with a number – usually somewhere between zero and ten, maybe more if you have a large family or you’re just weird. You write the number where it says to and you’re done.
The bigger the number you claim on your W-4, the less your employer takes out of each paycheck. The assumption is you’ll have those same basic dependents to claim come tax time, and that most years you’ll either still be as married or single as you were at the start of the year. The goal is for the figures – what you’ve paid throughout the year and what you owe in April – to come out roughly the same. If you owe too much, lower what you’re claiming on your W-4. If you’re getting a big refund each year, raise what you’re claiming. A little tax management now can make your April far less stressful.
Tax basics don’t get much more basic than that.
What If I Have Additional Income?
If you have significant income from sources which don’t withhold federal income taxes (or anything else) throughout the year, you have several options:
You can pay estimated taxes throughout the year. The traditional way to do this is quarterly – every three months. If you’d like to know more about how this works, the IRS is happy to tell you all about it. (If you make enough non-traditional income, this might even be required.)
You can set up a separate emergency fund account for taxes – your own unofficial “escrow” account. Each time you make that big sale or get paid for contract labor or freelancing work, set a percentage of that pay aside specifically for taxes. I always estimated a quarter or so, not because I was ever dead on with my guesswork, but because that got me close enough that I could manage the difference either way come April 15th.
You can choose to have your “traditional” employer withhold additional taxes from each paycheck by claiming a lower number on your W-4 than is required by the instructions and your calculations. There’s nothing illicit or shady about this; the government is more than happy to have more of your money up front and not have to worry as much about your ability to pay months later.
Don’t be afraid to get tax help on some of this stuff. Just like there’s no shame in going to a doctor for medical help or a lawyer for legal help, when our circumstances move past tax basics, it might be time to secure some professional guidance.
Personal Organization Tax Basics: Open Your Mail
There are several things you should be receiving in the mail, usually in January or early February, necessary for filing your income taxes.
The biggest thing you’re looking for is your W-2. You should get one of these from each traditional employer you have. It shows several things, but first and foremost it indicates how much Federal Income Tax was withheld for you the previous year, how much Social Security, and how much Medicare Tax.
If you did any contract labor or freelance work, you’ll also receive a 1099 from each institution who hired you. You’ll notice the 1099 does not show how much FIT or anything else was withheld from your check, because they weren’t withheld. You’re responsible for that yourself. This is where it’s important to have kept track of business-related expenses and such throughout the year, so you can deduct some of those from your taxable income. That’s an issue for another post, and an indication you might want to consider some additional small business tax tools to help you maximize your refund for your business – or at least minimize what you owe – by all legal means available.
You may receive miscellaneous other forms of interest to your tax return. You don’t necessarily have to know what all to expect in advance, but maybe pay a bit more attention to what’s showing up during this time rather than assuming it’s all junk mail and tossing it. Most of it will indicate it’s for your taxes once you open it.
Income Tax Basics: Deadlines and Extensions
I said before that I wasn’t going to tell you what to do. It turns out that’s not entirely true, because I’m about to insist on one thing you absolutely must do. It’s one of the most fundamental of all tax basics, and yet so many people don’t give it their full and proper attention.
File. On. Time.
Usually, that’s April 15th by midnight. I wouldn’t wait until then, but definitely don’t wait until after. For those of you who are “last possible second” types, here’s what the I.R.S. says about slipping in at the deadline:
Your return is considered filed on time if the envelope is properly addressed, has enough postage, is postmarked, and is deposited in the mail by the due date. If you file electronically, the date and time in your time zone when your return is transmitted controls whether your return is filed timely. You will later receive an electronic acknowledgement that the IRS has accepted your electronically filed return.
What Happens If I’m Late?
That depends on which part you’re late with.
If you file on time and owe money you don’t have, the penalty is 0.5% of what you owe for each month you don’t pay. If your bill is $5,000, for example, that’s $25 per month. If you don’t file on time and owe money, the penalty is 5% of what you owe for each month you don’t pay. That’s $250 per month, so… ouch.
Let’s look at each situation separately.
What Happens If I Can’t Pay the I.R.S. by April 15th?
If you’ve done your taxes for the year and you owe money but don’t have it, contact the I.R.S. and work out payment arrangements, just like you would with anyone else to whom you owed money. You can also pay by credit card, although there are additional fees for doing it this way. Whether or not using plastic is a good idea in this case depends on what kind of terms you have on your credit card(s). It might make sense, or it might actually be less expensive to simply work out a payment plan directly with the I.R.S.
Keep in mind that they’re a government agency. Technically they work for all of us. So, on the one hand, they’re not “out to get you,” no matter how it might feel sometimes; on the other, they will get you, eventually, if you try to avoid paying your share, or even if you’ve simply been careless and fallen behind.
Obviously, you should pay all of your valid debts, from the national government to that department store card that seems to keep getting the best of you. But let’s be real – the I.R.S. has leverage that J.C. Penney doesn’t. If you don’t stick to whatever payment plan you negotiate, or if you don’t take the initiative to work one out to begin with, the I.R.S. will shift into “collections” mode. This starts with letters (never phone calls or emails – if you’re contacted by any means other than a paper form in the mail, it’s probably someone trying to scam you) reminding you of your debt and adding the latest interest and penalties and such.
If that doesn’t do the trick, they can do several other things:
Federal Tax Lien – This is essentially a giant legal notice to creditors that the I.R.S. has “dibs” on your property, future income, etc. Anyone else with a claim can get in line. It also means no one is going to loan you enough for coffee and donuts until this is resolved.
Tax Levy – This is the next step in which the government actually seizes your property. Keep in mind that the I.R.S. doesn’t really want your house, car, or whatever; they’ll take it to make a point if you simply refuse to stick to those payment arrangements, however.
Wage Levy – This is the fancy federal version of “garnishing your wages.” If you won’t pay voluntarily, they I.R.S. can increase what’s withheld from your paycheck, all the way up to 100%. (OK, they don’t actually go up to 100% most of the time, but the point is PICK UP THE PHONE AND WORK OUT PAYMENT ARRANGEMENTS!)
Tax Evasion Charges – We usually only see this with big money folks, but legally this could happen to any of us. It may be uncomfortable to talk to the I.R.S. about your back taxes, but it’s probably less uncomfortable than jail time.
Revoking Your Passport – This isn’t a huge concern for everyone, but for those of us who need our passport, we really need our passport. This is just additional leverage to make sure you pay what you owe.
Scary Income Tax Basics: What Happens If I Don’t File by April 15th?
It’s very easy to file for an extension on getting your paperwork (whether online or on paper) completed and submitted. There’s no cost for requesting the extension, but a substantial cost to simply not filing on time.
Please understand, however, that the I.R.S. still wants any taxes owed. When you file an extension, you’re also expected to estimate any taxes due and send those in. If you are unable to do so, contact the I.R.S. to make payment arrangements as discussed above. Remember, there’s a small penalty for paying late; there’s a substantial penalty for filing late. You don’t have to like doing your taxes, but you’ll like not doing them far less, I assure you.
Also, if you don’t do your taxes, the I.R.S. can do them for you. They'll look at your income and decide what you owe, easy peasy! The problem is, they’re not particularly attentive to deductions or other mitigating circumstances which might lower what you owe. Not surprisingly, they tend to decide you owe pretty much the maximum it’s possible for you to owe. If you want those deductions and credits, DO YOUR TAXES ON TIME.
Even the Beatles had a famous song about the Tax Man. Just “Be thankful I don’t take it all”
Tax Basics: Final Thoughts
The time to start thinking about your taxes is now. You don’t have to panic, but you can start making sure you have a plan and that you’ll have what you need when April does arrive. It’s not like you can run to the tax store the night before and buy last-minute deductions and forms for everybody. And, If you decide you need a little help or guidance along the way, we can hook you up with the right folks.