If you are a person who quakes at the mere thought of filling out your tax form, even with the latest technology, you can alleviate some of the anxiety by understanding a little bit about the process. Knowledge is confidence. And, therefore, avoidance can only make you feel more anxious than you already feel. Think of taxes this way. You are simply giving the government a payment every time you are paid for the wonderful things that we take advantage of like military and police protection. When you pay your taxes in April, you are basically finalizing the overall billing for the year.
Withholding Taxes. The amount you elect to withhold from you paycheck is determined by the number of claimed allowances on the W-4 form you submit to your employer and your filing status (married, single, head of household, etc.). Unfortunately, most people, unbeknownst to them, have too much money taken out of their paychecks every month. This money could be put into a high interest savings account or be used to pay down current debt. Instead, it is given to the government and put in escrow, so to speak, for the entire year until it is refunded back to you. You are giving the government an interest free loan. Therefore, think twice before you allow your employer to withhold any extra money from you paycheck. Save the extra proceeds in a savings account or money market fund.
Personal Exemptions. When you fill out your tax form, you are automatically entitled to one exemption (you), which you can claim on your taxes. If you are married with no children, you are allowed two exemptions, or one exemption each for you and your spouse in a specific dollar amount. If you are single and make well over $100,000 or married and filing jointly and make well above $200,000, you are usually not afforded this option.
Qualifying Criteria. For most Americans, personal exemptions can significantly reduce the amount we pay in personal income taxes. Currently, the personal exemption amount is $3,650. Therefore, you are allowed an exemption, if you are married, for you and your spouse and each eligible dependent in your household. Congress established this as the level of income that should be insulated from taxation because it should roughly correspond to the minimum amount of money someone would need to get by at a subsistence level (i.e., enough money for food, clothes, shelter, etc.). If you have children, they qualify if they have lived with you for over half the year and did not supply more than half their own support. They should be under 19 years old by the year’s end unless they happen to be a full time student. In such case, they should be under 24 years of age.
Dependents. Generally, children who qualify as personal exemptions include adopted children, foster children, stepchildren, a taxpayer’s sister, brother, half sister, half brother, stepsister, stepbrother, or the grandchildren of a taxpayer’s children, siblings, stepsiblings, or half siblings assuming that the tax payer is responsible for providing the support for those children. That said, your claimed exemptions are then deducted from the calculated rate assessed on your adjusted gross income, or AGI.
Figuring the Tax Rate. America has a progressive tax system which increases as your income increases. Your individual tax rate is based on a percentage designated for the salary range where your income falls. For instance, let’s look at the listed 2010 tax rates for a single filer:
10% – Up to $8,375
15% – $8,375 – $34,000
25% – $34,000 – $82.400
28% – $82,400 to $171,850
33% – $171,850 – $373,650
35% – Over $373,650
If you made, say, $50,000, you would not simply multiply the amount you made by your AGI, or by 25% in this case, the rate listed for your income range. That would be too easy to understand. Instead, in the US tax system, an individual pays the listed percentage of income on each dollar that falls within that monetary range. So our tax payer who earned $50,000 of taxable income would be liable for 10% of the first $8,375 of income, then 15% for the next $25,625 earned ($34,000 – $8,375), and then finally 25% of each dollar earned between $50,000 and $34,000. The total tax bill would be $8,682 which is an average of 17%. That 17% is the real tax rate for someone earning $50,000 per year (before tax credits, dedications, etc. of course).
Knowing this information can assist you in your future tax planning efforts. Not only should you figure in your personal exemptions, but you should also consider your standard deduction and whether or not it is more practical to itemize. Also, you may want to increase your yearly contributions, say, to tax-advantaged accounts such as 401-k plans, Traditional IRAs, and Roth IRAs. Understanding your taxes can go a long way towards your financial wellbeing. Everyone should have a working knowledge of how our tax system works in order to know how to maximize it to your benefit and keep as much money in your pocket as possible.