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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.
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
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
- 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:
- Income
- Capital gains (or losses) from investments
- Retirement plan benefits
- Taxable pensions
- Rental income
Then subtract the following:
- IRA, SEP, or Keogh contributions
- Alimony payments
Taxable Income
This equals your AGI minus your personal exemptions, deductions,
and tax credits. This is the figure you use to calculate your
tax.
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U.S.
Tax System
