Income Tax Basics

The federal tax code can be utterly baffling, which helps explain why more than half of individual tax returns are completed by a tax preparer and many of the rest use tax software. Still, while every nuance of the tax code won’t be explained here, it’s important to understand the basics so you can better manage your annual tax bill.

How is your federal tax bill calculated? You start by adding up your gross income. That means toting up the money you received over the past calendar year from your job, investments, rental properties and elsewhere.

Next, you figure out how much of this income is taxable by knocking off your personal exemptions, standard or itemized deductions, and any other deductions you have, including those for retirement account contributions. You will likely discover there’s a large amount of income each year on which you pay no income taxes, though you may pay Social Security and Medicare payroll taxes on this money.

After that, you calculate how much you owe Uncle Sam on your taxable income. That isn’t as straightforward as it seems, thanks to the multitude of different tax rates, including seven federal income tax brackets, capital gains taxes, the alternative minimum tax and the Medicare surtax.

Finally, once you have figured out your total tax bill, you may be able to trim it by claiming various tax credits, such as the child tax credit and the credit for daycare costs. There are also various education tax breaks, which are discussed in the chapter devoted to college. All done? Unfortunately not. Many Americans then get to do it all over again, thanks to state income taxes. You can learn about the various taxes in your state using the interactive map at RetirementLiving.com.

Want to get a handle on your likely income tax bill? Try the Taxcaster income tax calculator from TurboTax.com. Meanwhile, to learn more about the federal tax code, check out the interactive tax forms at TaxPolicyCenter.org. The interactive forms explain each line on the tax return, including how many people are affected.

Next: Taxable Income

Previous: Where We Stand: Taxes

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