Tax regulations can be difficult, and tax software does not always make them easier to understand. Fortunately, certain basic laws and principles will help you grasp what taxes are and how they work, from the several sorts of taxes you must pay to the ability to exclude specific income from taxation.
What Is Taxable Income?
Gross income is defined as “revenue generated from whatever source.” Earned income and unearned income are the 2 categories of income that are taxed. Earned income consists of the following items:
- Unemployment benefits
- Sick pay
- Some non cash fringe benefits
Taxable unearned income may include:
- Profit from the sale of assets
- Business and farm income
- Rental income
- Gambling winnings
- Gifts and inheritance
Contributing to a retirement plan such as a 401(k) or an IRA can help lower taxable income.
What Is Your Effective Tax Rate?
Tax accountants frequently refer “effective” tax rate when they talk about your tax rate. Effective tax rate is lower than the top tax bracket in which you are classified. Rather, it’s the average of all the tax rates in which your earnings are taxed.
Suppose you earn around $20,000 per year. Nearly half of your income is taxed at 10%, while the other half is taxed at 12%, resulting in an effective tax rate of 11%.
Divide the amount of tax you pay by your adjusted gross income to obtain your effective tax rate. Even if two people are in the same tax bracket, the percentage of their income that falls into their highest (marginal) bracket determines their effective tax rate.
Reducing Your Tax Liability
Of course, you may use tax deductions to minimize your taxable income and so lower your marginal and effective tax brackets. You reduce the amount of income that goes into your marginal bracket when you claim deductions like child care, education expenditures, or professional development expenses.
Tax credits, on the other hand, are deducted from your tax bill directly to decrease the amount you owe, but they do not affect your tax bracket.
Tax Refunds vs. Tax Liability
One of three things may happen when you file your tax return.
You have overpaid tax if you paid more than you owe through withholding or anticipated payments. You’ll get a tax refund from the IRS. For example, you could finish your tax return only to discover that you owe $6,000 in taxes. The IRS will give you a $500 tax refund if you paid in $6,500 through withholding over the tax year.
You have a tax burden if you paid less tax than you owe in the end. When you file your tax return, you’ll have to pay the difference to the IRS. If your entire tax burden is $7,000 and you only paid $6,500, you owe the IRS $500. If you do not pay this sum by April 15, you will be charged interest and penalties by the government.
It’s possible that the tax you paid is precisely the same as the tax you owe in some situations. You will not owe money and will not receive a tax refund in this situation.
The Bottom Line
Although it is important to pay all taxes owing to the government, no one should be forced to pay more than is legally required. Several hours spent on the IRS website (IRS.gov) and scouring reliable financial information websites might result in tax savings of hundreds, if not thousands, of dollars.