For plenty of Americans, early April means taking a stack of W-2s, going to the kiosk in the local giant retail store, and saying to an overworked part-time employee, "Help me." It's amazing how many of us don't have even a passing familiarity with the basics of the tax code. Granted, it can be arcane and confusing at times, but there's a minimum level of understanding that every taxpayer should have. At the very least, you don't want to place too much trust in a third party to do your taxes. Know a few easily understandable concepts and terms, and there's less chance that you'll end up paying more in taxes than you need to.
The amount of your taxable income corresponds to a certain percentage that the government confiscates from you. The more you make, the higher that percentage - what they call a progressive tax structure.
We will use single people as our examples throughout, as opposed to married people or heads of households, for whom the numbers are different. If you're single, and your taxable income is under $8700, you pay 10% of it in taxes. That is your bracket.
Make $8,701 (or anything up to $35,350) and you are bumped up to the 15% bracket. That doesn't mean that you now pay 15% on everything, rather than 10%. It means that you still pay 10% on eveverything up to $8700, but you pay 15% on anything beyond that.
You might have read that capital gains taxes in the United States, already among the highest in the world, are about to enter the exosphere.
As of this writing, the Supreme Court is about to issue a ruling on ObamaCare. For some reason, the healthcare law has a clause or two regarding tax policy, and one of the law's provisions is that tax rates on ordinary income are going to rise to 43.4%. The mere mention of this plan causes many people to shake their heads, their fists and perhaps a carefully chosen digit on each hand.
Regardless of whether it is too high, the 43.4% figure is a marginal rate, as contrasted with an effective rate. That means it kicks in only above certain levels. Nobody is going to fork over 43.4% of his income to the IRS, and if anyone does, he needs a better tax accountant.
Take the current income tax schedule, which incorporates six increasingly higher brackets: 10%, 15%, 25%, 28%, 33% and finally, 35%. The vast majority of us - that is, everyone who makes under $388,351 a year, do not pay the 35% rate. All a marginal rate means is that once your (taxable) income increases from $388,350 to $388,351, you pay an extra 35 cents in taxes, and 35 cents for every dollar beyond. It is not as bad as it sounds: you paid considerably less than 35% on every step of the way up to $388,350.
Reductions in taxable income come in two forms, the weaker of which is deductions. Say you made $35,360 last year. A $100 deduction - and there are scores of these made available if you read the booklet that comes with your 1040 - would reduce your taxable income to $35,260. Not only would you pay less in taxes, that particular deduction at that level would drop you into a lower tax bracket. You would pay less across the board.
A credit is the other reduction, and it is subtracted from your tax obligation rather than from your income. As far as the IRS is concerned, it's as if you had never received the money.
Therefore, a credit is always several times better than a deduction. If you are in the 28% bracket, a $100 deduction saves you $28. A $100 credit saves you $100. Credits are plentiful - you just have to look for them. For instance, if you buy the right kind of approved hybrid vehicle, you could enjoy a credit up to $3400.
We touched on it earlier, but your taxable income is considerably different from your gross income. For the taxman's purposes, how much you make is secondary to how much you have remaining after exhausting every deduction and credit available to you. The natural human desire is to increase your gross income to the highest extent comfortable. Meanwhile, you want to get your taxable income as low as possible, capitalizing on every possible reduction before remitting your tax payment.
Unless you found it on the sidewalk or a dead relative bequeathed it to you, you earned it, right?
Well, in the eyes of the IRS, not necessarily. The tax agency distinguishes between earned and "unearned" income. Earned income includes not just wages and salaries, but strike benefits and whatever you pay yourself if you happen to own and operate a business. Unearned income includes such non-work-related earnings as interest and dividends. These are all classified as "ordinary income," which is taxed at a different rate than capital gains.
To simplify the definition for the purposes of our discussion, capital gains refers to any profit you realized (can't use the word "earned") throughout the year on your investments. Make $600 selling vacuum cleaners, whether on commission or salary, and that's ordinary income. Buy a $6000 speculative-grade bond on December 31 that promises to pay 10% annually, and if the issuer hasn't defaulted by the time a year elapses, that's a $600 capital gain.
The IRS doesn't just tax ordinary income at a different rate than capital gains, it taxes the latter at a lower rate. The reason there's a difference between the way taxes are levied on the two types of income is that it's supposed to reward people for investing in a new or existing business.
Capital gains are classified as either short- or long-term, the cutoff being one year. If you hold an investment for less than a year, you'll pay the same rates you'd pay as if you were receiving ordinary income. Hold your investments for longer than a year, however, and things change drastically. You pay nothing if you're in the 15% bracket or lower. If you are beyond the 15% bracket, you pay 15% and not a penny more. This is why some sources claim that Warren Buffett pays a lower effective tax rate than his secretary does.
The Bottom Line
Those are just the rudiments of tax terminology. Beyond this are more complicated concepts like the innocent-spouse rule, vested benefits, Section 179 and dozens of other esoteric terms that don't apply to everyone equally. However, for most if not all of us, knowing the above terms will improve your understanding of how income taxes work. At any rate, you'll be much better off than the people who invoke the services of a preparer on the afternoon of April 14.
More From Investopedia