U.S. Tax System
Did You Know?
- Americans started paying federal income taxes in 1913.
- Until World War II, taxes were paid as a lump sum at the end of the year.
- Income taxes once demanded just 6% of income from only the wealthiest citizens in the United States (compared to nearly 40% in recent years for some).
- During World War II, the government started withholding a portion of our taxes from each paycheck so that it had a steady stream of income to fund the war, a practice that continues to this day.
- The American tax code has become the biggest, most complicated document ever assembled. Our tax code has more than 7 million words and counting, compared to the Bible, which has about 700,000 words.
- The IRS has more than 100,000 employees. By contrast, the FBI employs just over 11,000 people.
Common Tax Elements
Before learning the core basics of tax planning, it is helpful to start with an explanation of the basic elements of the U.S. tax system. Once you grasp their meaning, you can more effectively negotiate the tax system.
The W4 Form
The form that you fill out when you start a job is called the W4 form. This is where you list your “withholding allowance information,” which is no more than an estimate of how much you’re going to owe at the end of the year (based on predicted income minus predicted deductions and exemptions). On the basis of this estimate, your employer deducts a certain amount of money from each paycheck for taxes. This amount is your withholding.
The W2 Form
At the end of each tax year (January), your employer is required to send you a W2 form that reports exactly how much you made and how much was withheld for taxes. The W2 and W4 forms contain most of the information that people need to file their income tax. It excludes information regarding income from investments, itemized deductions, other taxes, and tax breaks that don’t apply to everyone (i.e., the yacht tax).
Exemptions are the amount you can subtract from your income (thereby reducing the portion of your income that can be taxed) simply for being alive, married, and/or having kids (or more precisely, dependents).
- Deductions are personal expenses that the government allows you to subtract from your income. You can take your deductions in 1 of 2 ways: either as a standard or an itemized deduction.
- A standard deduction is a set amount that the government allows you to take just for filing your taxes.
- If you itemize your deductions, you separately list (and must document) all the deductions you qualify for and their amounts.
- Since you get to choose which kind of deduction you’re going to take, the trick is to figure out which of these options gives you a higher deduction.
Adjusted Gross Incomes (AGI)
AGI is your total earned and unearned income from taxable accounts. To calculate it, add up the following:
- Capital gains (or losses) from investments
- Retirement plan benefits
- Taxable pensions
- Rental income
Then subtract the following:
- IRA, SEP, or Keogh contributions
- Alimony payments
This equals your AGI minus your personal exemptions, deductions, and tax credits. This is the figure you use to calculate your tax.