The Tax Process
Today, the American tax system can be likened to a perpetual motion machine. While most Americans tend to only think about the tax system and the Internal Revenue Service (IRS) as the month of April approaches, it's actually a never-ending process. Let's take a look inside the tax system and examine its various steps. For our purposes, a good way to explain how the system works is to watch one American income earner -- let's call him Joe -- as he goes through a year of the American tax process.
The tax process begins when Joe starts his new job. He and his employer agree on his compensation, which will be figured into his gross income at the end of the year. One of the first things he has to do when he's hired is fill out all of his tax forms, including a W-4 form. The W-4 form lists all of Joe's withholding allowance information, such as his number of dependents and child care expenses. The information on this form tells your employer just how much money it needs to withhold from your paycheck for federal income tax. The IRS says that you should check this form each year, as your tax situation may change from year to year.
Once Joe is hired and given a salary, he can estimate how much he will pay in taxes for the year. Here's the formula:
- Start by assessing gross income, which includes work income, interest income, pension and annuities.
- Subtract any adjustments (examples: alimony, retirement plans, interest penalty on early withdrawal of savings, tax on self-employment, moving expenses, education loan interest paid). The difference is the adjusted gross income (AGI).
- Once the AGI is calculated, there are two choices: Either subtract a standard deduction, or subtract itemized deductions, whichever is greater. Itemized deductions might include, but aren't limited to, some medical and dental expenses, charitable contributions, interest on home mortgages, state and local taxes and casualty loss.
- Next, subtract personal exemptions to end up with taxable income.
- Go to the IRS tax tables if taxable income is less than $100,000, or to the IRS tax rate schedules if it's more than $100,000. This is where it gets a little complicated, because the United States uses a marginal tax rate system. There are six tax brackets: 10 percent, 15 percent, 25 percent, 28 percent, 33 percent and 35 percent. How the tax rate works depends on income and marital status. For those using the tax table, look for taxable income on the chart to find gross tax liability. For those making more than $100,000, use the tax-rate schedule to figure gross tax liability.
- From your gross tax liability, subtract any credits. Credits may include such items as child care. The difference is the net tax, which is how much to pay or how much of a refund to expect.
At the end of each pay period, Joe's company takes the withheld money, along with all of withheld tax money from all of its employees, and deposits the money in a Federal Reserve Bank. This is how the government maintains a steady stream of income while also drawing interest on your tax dollars.