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Unformatted text preview: Federal Individual Income Tax A Primer by Eric Rall on April 6, 2010 in Economics , Misc Personal , Politics Its tax season again, and its recently struck me that an awful lot of people dont really understand how the income tax works, and Im not talking about the nitpicky details in the thousands of pages of tax codes (nobody understands those, at least not all at once). Some people have never done their own taxes, and even people who are fairly adept at getting their own tax forms filled out and filed correctly have gaps in their understandings which have significant policy and personal finance implications. Over the course of the year, the IRS peels off a portion of every paycheck based on an estimate of the taxes well owe (we have Milton Friedman and Donald Duck to thank for this). And then, the following Spring, we fill out a bunch of forms to calculate what we actually should have owed, and either send in a check to cover the underwithholding or apply for a refund for overwithholding. From a personal finance perspective, you want to withhold just enough to be confident of avoiding penalties for underwithholding; a big refund is a big interest-free loan to the government. The first step in calculating your income tax liability is to calculate your income. You add up all your wages, tips, short-term investment income, business and rental profits, etc, and you subtract out your personal exemption; business, rental, and investment losses; contributions to tax-deferred retirement accounts; etc. The number you come up with at the end of this process is your Adjusted Gross Income (AGI) . Theres also several numbers called Modified Adjusted Gross Income (MAGI) which you may have to calculate later on to figure out if youre eligable for deductions and credits which phase out when your income is too high; there are four or five different MAGI, each with its own formula, where you add back in certain things you subtracted out of your AGI. Next, you calculate your Taxable Income . You have a choice here: you can either add up all the Itemized Deductions youre eligable for (the big ones for most people are state taxes, mortgage interest, and charitable contributions), or you take the Standard Deduction which is a flat dollar amount based on the number of people in your household. Usually, the standard deduction is higher unless you own a house with a mortgage or you have a large income in a state with high taxes. Whichever number you chose, you subtract from your AGI to yield your taxable income. Then you add up the taxes youve already paid. Paid is in scare quotes because this step includes Tax Credits , which is money the IRS pretends youve paid them if you do certain things policymakers like. Once you add up all the taxes youve actually prepaid (mostly withholdings, but also quarterly estimated tax payments if you make them (usually only people who own small businesses do this)), you compare this to what you...
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