Issue 12  •  Spring 2013

Nothing for Money: The Why’s and How’s of Taxes

Written by Andrea Davila
Illustration by Famke Schoonbergen
Dying to go backpacking with your best friend around Romania? Want to learn how to fly an airplane? Committed to opening an animal shelter? While learning about and maintaining your financial health might not seem as cool as any of the above, it is one of the most important tools you can have to help you create the life you dream of living, and do all the things you dream of doing. Money for Nothing aims to demystify that scary and confusing world of personal finance for all us normal folks out there.

In this installment of Money for Nothing we’re talking about what some might call “nothing for money”—taxes! As you might have already experienced when getting your first “real” job and paycheck, taxes play a big role in the difference between your expected and your actual paycheck. Today we’ll look at why that is, where your money goes, and the process through which you reconcile your earnings with Uncle Sam, a process we like to call “filing your taxes.”

While discussing taxes, there are a few important things to know about:

1. The American Tax System

Clearly, the US government needs money to run its operations. It has roads to fix, educations to provide, laws to pass, etc. The majority of this revenue comes from various forms of taxes:

A. Individual Income Taxes: These are the taxes we most often associate with the term “taxes.” And rightly so, since it’s the largest source of tax revenue for the federal government, providing over 43 percent of total tax revenues. The income tax system is progressive, meaning that high-income households and individuals are taxed more than low-income households and individuals. Unlike a proportional system, where everyone pays the same proportion of their income toward taxes, a progressive system implies that the share of income paid in taxes rises with income level. Tax brackets, as we call them, are a way to organize a progressive tax system, by bucketing income levels and charging higher income percentages to taxes as incomes rise above those levels. If, for example, you made $7,550 this year (the most that you can make in the first tax bracket) 10 percent of your income would be taxed; if however you made $8,550, and moved into the next tax bracket, the government would still take the first $7,550 that you made at the 10 percent rate, but the last $1,000 would be taxed at the second tax bracket's rate, which is 15 percent plus $755. That’s why there is a difference (and you should know this!) between your marginal tax rate, or “tax bracket,” and your overall tax rate, or what actual percent of your income you pay toward taxes. For a clear description of this (and the ability to plug in your own numbers), see here.

B. Corporate Income Taxes: Just like individuals pay taxes on their earnings, corporations pay taxes on their revenues. You don’t need to know much about this unless you’re starting your own business, but it’s nice to know that those ballers at Citigroup have to pay taxes too. Corporate income taxes only account for around 7 percent of tax revenues.

C. Payroll Taxes: In addition to the taxes marked Fed Income Tax (or also called: FWT, FT, or Fed Tax) and State Income Tax (or also called: ST Tax, ST, SWT, or NY Income Tax) that are taken out of your paycheck and explained above, you also pay taxes to fund Social Security and Medicare. These payroll taxes are called social insurance taxes, since they pay for services that provide insurance—like medical care, pensions, and disability benefits—to Americans in need. These taxes may also be marked FICA (or Federal Insurance Contributions Act). Two things about FICA taxes are unique: one, the employer also has to pay them in addition to the revenue taxes mentioned above; and two, unlike income tax, FICA tax is regressive, meaning you pay less as you make more.

2. The W-4!

If you’ve done your homework and figured out your overall tax rate, you should have a sense of how much you’ll owe the government in taxes for 2010. But when do you pay? Since your tax liability (i.e., how much you owe) is probably a big chunk of change, the government doesn’t want you to have to fork it over all at once. Instead, the government prefers you to pay as you go, taking a bit from each paycheck. How do they know how much to take from each paycheck? Easy—you tell them when you fill out your W-4. The W-4 allows you to communicate to the government the specifics of your tax situation, like if you’re married or single, and how many withholding allowances you are planning to claim. The government then auto-calculates your tax bracket, annualizing each paycheck and taking your W-4 information into account.

Why does it matter how many allowances you claim, or if you are single? Well, because married households and households with small children or elderly relatives get a break on their taxes. The government needs to know this information in order to calculate how much tax to take from every paycheck. A short primer on how to fill out the W-4 can be found here

3. Filing Taxes

By January 31st of each year, your employer has to send you a W-2, which is different from the W-4 form you fill out to show your withholdings. This W-2 tells you how much you’ve paid in taxes for the past calendar year and is useful in helping you figure out if you owe taxes or will be refunded. Taxpayers usually have until April 15th to file their tax returns for the previous year and pay any taxes they owe (though this year it was April 18th due to Emancipation Day, a holiday observed in the District of Columbia that fell on the 15th). Unless, of course, you file for an extension (which you may very well have done if you’re reading this article right now!). In that case, you have until October 17 to file your tax returns (though you would have already had to request an extension by April 18th).

If, during the year, you’ve overpaid taxes, you’ll be refunded at the end of the year. If you’ve only had one employer and only lived in one state during the year, filing taxes is a pretty painless process. You can do it yourself, for free, by filling out the 1040EZ online through one of the many providers here.

If you’re in need of more complicated advice, you should consult a tax specialist, who will typically charge you to prepare and file your taxes. Here’s a great link to advice on finding an accountant.

While doing your taxes might seem incredibly daunting, it is helpful to know some of the basics of the tax system. Even if you are never a professional accountant, you should know the right questions to ask and feel empowered enough to learn more about your own financial situation.

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