Federal Income Taxes — the Basics

By having income taxes withheld from your paycheck each pay period, you're really prepaying an estimate of the taxes you'll owe for the year. You settle up your bill with Uncle Sam when you prepare your tax return after the end of the year.

The W-4 Form

The amount you have withheld is calculated based on your filing status (married or single) and the number of withholding allowances you claim on the W-4 form you file with your employer. You should file a new W-4 with your employer if you:

  • Got a big refund last year

  • Owed over $100 last year when you filed your tax return

  • Got married or divorced

  • Had a child

  • Can no longer claim a dependent that you claimed last year

Most people have too much tax withheld and let the IRS borrow their money interest-free all year. You could be earning interest on that money or saving between 12 and 20 percent in interest charges by using the extra money to pay down credit card debt.

The only time it makes sense to have more withheld than you're going to owe is if you find it impossible to save money on a regular basis. You could accomplish the same thing by having a fixed amount automatically deducted from your check each month and deposited in a savings account.

Exemptions

An exemption is a gift from the IRS, a fixed amount you deduct from your taxable income for yourself, your spouse if you're married, and each eligible dependent you claim on your income tax return. In 2007, each exemption was worth $3,400, so if you're married but have no kids, you can claim $6,800 if you file jointly. The exemption phases out at certain income levels but unless you're single with income over $156,300 or married with combined income over $234,000, you'll be able to take the full deduction. You have to pass five tests for each dependent in order to claim them on your income tax return. See Section 3, Part One, of IRS Publication 17 for details.

Marginal and Effective Tax Rates

Your income is taxed based on taxable income brackets, ranging from 10 percent to 35 percent, as shown in the tax bracket table in this chapter. The higher your income, the more tax brackets you'll cross, with the income that falls within each bracket being taxed at the rate for that bracket.

2007 Tax Bracket Limits

*Income in excess of these amounts is taxed at 35 percent
Filing Status 10 percent 15 percent 25 percent 28 percent 33 percent*
Single $7,825 $31,850 $77,100 $160,850 $349,700
Married filing jointly/Qualifying Widow(er) $15,650 $63,700 $128,500 $195,850 $349,700
Married filing separately $7,825 $31,850 $64,250 $97,925 $174,850
Head of household $11,200 $42,650 $110,100 $178,350 $349,700

For example, if you're single and your adjusted gross income (AGI) is $40,000, your tax would be calculated as follows:

The first $7,825 at 10 percent = $782.50.

The next $24,025 (the difference between $31,850 and $7,825) at 15 percent = $3,603.75.

The next $8,150 (the difference between your AGI of $40,000 and $31,850) at 25 percent = $2,037.50.

That means your total tax burden would be $782.5 + $3,603.75 + $2,037.5= $6,423.75.

Your effective tax rate (or average tax rate) is the tax rate you actually pay on your total income, considering that part of your income isn't taxed at all due to exemptions and the standard deduction or itemized deductions, and part of your income may fall in different tax brackets. To calculate your effective federal tax rate, divide your total federal income taxes for the year (from your latest tax return) by your total income. If your marginal rate is 25 percent, your effective tax rate may be between 15 and 17 percent.

If all this talk about marginal tax rates seems confusing, just remember that if your marginal rate is 25 percent, then 25 percent of any additional earnings will go to the IRS, and additional tax-free or tax-deferred deductions will produce savings of 25 percent. This is important information for tax planning.

Your marginal tax rate is the rate you pay on your highest dollars of income. Look up your total income (including capital gains, interest income, and so on) in the tax bracket table. Your marginal rate is the percentage shown in the column that your total income falls into. For example, if your income is $40,000, your marginal tax rate in 2007 is 25 percent. Your marginal tax rate tells you two important things: how much you'll gain by reducing your taxable income, and the true cost of a tax-deductible expense.

For example, if you want to increase your tax-deferred contributions to your employer's 401(k) plan by $100, you could quickly calculate your real out-of-pocket expense by using your marginal tax rate of 25 percent and your state tax rate, which we'll assume is 6 percent for purposes of the example. Since 401(k) contributions aren't subject to federal or (in most states) state taxes, the $100 could go into your account with only $69 coming out of your pocket (savings of 25 percent + 6 percent = 31 percent; $100 – 31 percent = $69). You'd save $31 in federal and state income tax by reducing your income $100. You don't find deals like this every day.

You can also quickly calculate the real value of additional income, such as overtime, bonuses, or a second job, which will be taxed at your marginal tax rate. If your marginal federal tax rate is 25 percent, $1,000.00 in extra income will net you around $593.50 (7.65 percent for social security taxes, 25 percent for federal income taxes, and 6 percent for state income taxes for purposes of our example, for a total tax rate of 38.65 percent; $1,000.00 × 38.65 percent = $386.50 in taxes; $1,000.00 – $386.50 = $613.50 net pay).

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