How Federal Taxes Work


You won't want to hear this in April, but we need federal taxes to play for governmental services like municipal infrastructure, public education and much more.
You won't want to hear this in April, but we need federal taxes to play for governmental services like municipal infrastructure, public education and much more.
Ken Reid/Getty Images

Running a country is ridiculously expensive. In fiscal year 2009, the U.S. federal government spent a staggering $3.5 trillion [source: US Treasury]. To cover its many costs, the federal government collects taxes from individuals and businesses. In 2009, the government raised $2.1 trillion in individual and corporate taxes -- still leaving a budget deficit of more than a trillion dollars.

The economic logic of federal taxes is that citizens should pay for services that benefit the common good. Federal taxes pay for national defense, police and fire departments, municipal water and sewage infrastructure, highway construction and maintenance, hospitals and public education.

Taxes also fund the regulatory activities of the government. Environmental regulations ensure the safe disposal of potentially harmful waste materials. Consumer regulations protect us from fraud and illegal monopolies. We rely on the government to regulate the safety of food, products, construction and more. They also pay for support programs like unemployment compensation, financial and medical aid for the elderly or disabled, social services for low-income families and extra support for families with young children [source: US Treasury].

The abiding principle of U.S. federal taxes is that everyone should be taxed according to their ability to pay [source: US Treasury]. That's why we have progressive tax rates that increase with the amount of money you make. There's also a built-in system of deductions, exemptions and tax credits designed to balance the tax burden on those with children, medical bills, business losses or other expenses.

Although we think of tax day as April 15, most of us pay taxes all year long [source: TurboTax]. Federal income taxes are withheld from each paycheck, as are contributions to social security and Medicare. These funds are deposited in government accounts, reducing the government's expenses [source: US Treasury].

Filing and paying federal taxes is voluntary: The individual or business must calculate the taxes owed and pay them in a timely manner [source: IRS]. The IRS doesn't calculate your taxes or knock on your door to collect. Voluntary does not, however, mean optional. People have tried to argue this in court and have failed miserably. If you don't pay, you could be fined or even thrown in jail. Just ask Al Capone.

April 15 wasn't always such a dark day. Read more about the history of federal taxes.

 

History of Federal Taxes

Section 8 of the U.S. Constitution reads, "The Congress shall have Power to lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence [sic] and general Welfare of the United States." The earliest federal taxes were exclusively tariffs -- taxes on imported goods -- and excise taxes, sales taxes on certain items. Whisky, for example, was charged a steep excise tax in 1791, leading to the Whisky Rebellion of 1794.

The first federal income tax was created in 1862 to help fund the Civil War, but was abolished soon after. That first income tax required the appointment of a commissioner of Internal Revenue. The name didn't change to the Internal Revenue Service until the 1950s.

Congress tried to impose a flat federal income tax rate in the 1890s, but it was rejected by the Supreme Court. In 1907, President Theodore Roosevelt tried to reintroduce the income tax, proposing a progressive rate system that would tax each income class according to its means [source: Tax History Museum]. In 1913, 36 states ratified the 16th Amendment to the Constitution, giving the federal government power to directly levy income taxes.

In 1914, the Bureau of Internal Revenue issued the first personal income tax form, the 1040. Here's what it looked like. Individuals paid one percent on income over $3,000 ($4,000 for married couples) with an additional surtax between one and six percent, depending on income level [source: Tax History Museum].

After World War I, Woodrow Wilson raised the personal tax rate to two percent for income over $1,000 ($2,000 for couples) and added an eight percent tax for incomes over $6,000 [source: Tax History Museum]. By 1919, those with the largest personal income were paying as much as 77 percent in federal taxes! Luckily for those folks, it was back down to 50 percent by 1921.

In response to the widespread poverty caused by the Great Depression, particularly among the elderly, Roosevelt called for an "old-age" insurance program as part of his sweeping New Deal reforms. The Social Security Act of 1935 provided that security blanket, establishing the Federal Insurance Contributions Act (FICA) tax to pay for Social Security benefits [source: US Treasury].

The Revenue Act of 1935 introduced the Wealth Tax, raising the tax rate back up to 75 percent for the wealthiest people and addressing the trend of these people evading taxes through loopholes [source: IRS]. The Victory Tax of 1942 saw the first automatic withholding of income tax from worker's paychecks.

President Lyndon B. Johnson signed Medicare and Medicaid into law in 1965. Tax rates rose to fund the increased medical coverage. By 1980, the combined payroll tax -- the amount paid by individuals and their employers to fund Social Security and Medicare -- was 12.3 percent.

Personal Income Tax Brackets

Your marital status and income level determine your tax bracket.
Your marital status and income level determine your tax bracket.
Eric Anthony Johnson/Getty Images

Federal income tax is progressive, meaning that the more money you make, the more you're expected to contribute. Every year, the Internal Revenue Service (IRS) publishes a Tax Table, commonly referred to as the tax brackets, which details the amounts and percentages owed in federal taxes by each income level and each type of filer: single, married filing separately, married filing jointly or head of a household.

The IRS defines your filing status as your condition on Dec. 31 of the tax year. So if you were single in 2009, but got married in January 2010, you still file your 2009 tax return as a single filer. Most married people opt to file jointly because tax rates are generally lower than applying separately, but everybody has their unique financial situations. But what does it mean to file as a head of household?

Head of household filing status applies to a specific set of circumstances. You can only apply as head of household if you were unmarried or "considered unmarried" at the end of the tax year, you alone pay more than half the cost of keeping up a home for the year (not necessarily your own home) and a "qualifying person" lived in that home for more than half the year. If the qualifying person is a parent, he or she doesn't have to live with you [source: IRS].

You're "considered unmarried" if your spouse didn't live with you for the last six months of the year and you're filing separately. As for qualifying persons, those could be either children -- natural, foster, stepchildren -- or relatives, including parents, grandparents, uncles, aunts, nieces, nephews, grandparents, brother-in-laws, son-in-laws and everyone in between. You need to prove that you provided more than half the financial support of the qualifying person during the tax year.

Once you determine your filing status, you can look up your taxable income on the IRS Tax Table to see how much taxes you will owe. Remember, this is taxable income, not total (or gross) income. (We'll talk more in the next section about the difference.) Also remember that your tax burden can be lightened by withheld taxes, deductions, exemptions and credits.

Remember that not everyone has to file a federal income tax return. You only have to pay federal income tax if you earned a minimum amount of money for your age and filing status. The IRS has a table for this, too. For example, if you're single, under 65 and earned at least $9,350, you must file a tax return. If you're married, filing jointly and both over 65, you need to have earned $20,900 to pay taxes. If someone has claimed you as a dependent, you don't have to file if you make less than $5,700.

Taxable Personal Income

The simple purpose of the 1040 federal income tax form -- despite its baffling appearance -- is to calculate how much money you earned and how much of that money should be taxed. To do this, you start with your total or gross income, deduct certain expenses to get a number called your adjusted gross income (AGI) and then subtract even more deductions and exemptions to arrive at your taxable income.

To figure out your total income, you need to add up everything that could possibly be considered earnings. The first major income category is wages, salaries and tips. If you work for someone else, you will receive a W-2 form in February that lists your total salary, wages and tips for the year. If you are an independent contractor, you will receive a 1099 form from your clients with income listed under "nonemployee compensation." If you're self-employed, keep track of your own earnings or losses and enter them in Schedule C of the 1040.

Then there's every other type of income. If you collected interest or dividends on investments like stocks, CDs or money market accounts, you need to report that as income. If you sold stock, real estate or collectibles for a profit, then you need to report that income as a capital gain. Alimony, pensions, annuities, farm income, royalties and trusts , even your Social Security benefits -- the IRS wants a piece of it all. (The only tax-exempt income is unemployment compensation up to $2,400 a person [source: IRS].) Add all of these earnings together to get your total income.

The adjusted gross income is your total income minus a few specific deductions. Some examples are self-employment tax (you can deduct half of the amount from your total income), moving expenses, certain health care costs, student loan interest, tuition and alimony. Add those together and subtract them from the total income to calculate your AGI.

To arrive at your taxable income, you need to subtract deductions and exemptions. Many people take the standard deduction, which is a lump sum based on your filing status. Other people itemize their deductions, submitting receipts for every major and minor qualifying expense. The IRS only cares about the higher number.

Everybody is entitled to at least one personal exemption, valued at $3,650. But you can also claim exemptions for your spouse and qualifying dependents. A family of four can deduct $14,600 from their AGI. Once you subtract exemptions and deductions from your AGI, you're left with your taxable income. This is the number you plug into the Tax Tables to figure out how much you owe in federal income tax.

Personal Income Tax: Refund or Payment?

When you file your federal income tax return, be sure that you claim enough withholding allowances to cover your tax obligations.
When you file your federal income tax return, be sure that you claim enough withholding allowances to cover your tax obligations.
Tom Grill/Getty Images

When you get a job, one of the first things your employer will ask you to do is fill out a W-4 form. The main purpose of the form is to figure out how many withholding allowances you qualify to claim. The more allowances you claim, the less federal income taxes are withheld from each of your paychecks.

Everyone gets one allowance, but there are additional allowances for your spouse and dependents, and even more if your spouse doesn't work and your dependents qualify for child tax credits. A family of four with a nonworking spouse and two young children can claim up to 10 allowances. This means more money in the family's pocket during the year. The same family could claim fewer allowances, but then they would pay more income tax with each check and receive the overpaid taxes in one lump sum as a tax refund.

If you regularly receive a refund greater than $1,000, you should check your W-4 and make sure you're claiming enough allowances. If you regularly pay taxes equaling more than 10 percent of your total income, then you should claim more allowances [source: TurboTax]. If you're self-employed, then nothing is automatically withheld from your earnings and you simply pay estimated income taxes four times a year. If your employer has already withheld income taxes, that total will appear on your W-2. You can subtract that amount from your total income taxes.

The last way to lighten your tax load is through tax credits. Tax credits directly reduce your tax liability, unlike deductions and exemptions, which only reduce the amount of income subject to tax [source: 1040.com].

There are two types of tax credits: nonrefundable and refundable. Nonrefundable tax credits can reduce your taxes to zero, but not below zero (a refund). Examples include the Child Tax Credit, Education Credit, Dependent Care Credit and Retirement Savings Contribution Credit. Refundable credits can reduce your tax burden below zero, adding up to a refund. They include Earned Income Credit (for low-income filers), First-Time Homebuyer Credit and the Health Coverage Tax Credit.

After you've subtracted all available credits and withholdings from the total taxes you owe, you will have either a positive or negative number. A positive number means you still owe income taxes. A negative number means a refund.

If the IRS owes you a refund, it can mail you a check or direct deposit your money in up to three different accounts.

Business Income Taxes

Businesses are subject to income taxes, just like individuals. The amount of income tax a business pays depends on how much it earns and how it's structured. The IRS requires different tax forms and charges different tax rates for sole proprietorships, partnerships, C corporations, S corporations and limited liability companies (LLC). Nonprofit organizations -- those that successfully apply for 501(c) status -- pay no federal income taxes at all.

A sole proprietorship is a business owned and operated by a single person. In this case, the IRS treats all business income as personal income, so everything is taxed at the personal income tax rate. Since a sole proprietor is also self-employed, he or she will also have to pay self-employment tax to cover Social Security and Medicare contributions.

A partnership is when two or more people jointly own a small business. The partnership itself is treated as an employer, but the individual members of the partnership aren't employees. For tax purposes, they're self-employed. The individuals don't pay taxes on the earnings of the partnership. The earnings are "passed through" to the individuals, who pay normal income tax using form 1040, schedule C. The partnership, however, being an employer, must withhold and pay payroll taxes.

C corporations, which are owned by shareholders, are actually taxed twice. The corporate earnings are taxed at corporate rates. The shareholder distributions are taxed again at personal income tax rates. Corporate tax rates also increase with taxable earnings. If the corporation earns between $0 and $50,000, the tax rate is a flat 15 percent. If it earns between $50,000 and $75,000, the rate is $7,500 plus 25 percent of the amount over $50,000. If it makes between $10 million and $15 million, the tax is $3.4 million plus 35 percent of the amount over $10 million.

Just like individuals, businesses can lower their tax burden by deducting expenses and claiming tax credits. Why do you think they have accounting departments?

S corporations are small domestic corporations with no more than 100 shareholders. To avoid double taxation, all earnings are passed through to the shareholders, who are taxed at their personal income rate.

Limited liability companies (LLC) aren't recognized by the IRS as a unique tax entity. Members of the LLC must therefore pay taxes as either a corporation, partnership or a sole proprietorship.

Are those the only taxes that businesses have to pay? Not quite. Next we'll talk about payroll taxes.

Business Payroll Taxes

Businesses have to pay payroll taxes as well as federal taxes.
Businesses have to pay payroll taxes as well as federal taxes.
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Any business that has employees must pay payroll taxes, also known as employment taxes. Payroll taxes include money withheld from each employee's paycheck and money paid directly by the employer.

As we mentioned earlier, businesses use an employee's W-4 form to calculate how much federal income tax should be withheld from each paycheck. The employer must also withhold Social Security and Medicare contributions from each check. These are collectively listed as FICA contributions. Employees are taxed 6.2 percent for social security (up to $106,800) and 1.45 percent for Medicare. But here's the kicker: The employer must match those contributions, raising the total FICA contributions to 15.3 percent [source: IRS].

In addition to federal income tax and FICA contributions, employers must pay Federal Unemployment Tax (FUTA) for every employee who makes at least $1,500 a year. In the case of FUTA, no money is withheld from the employee's paycheck. The employer pays the full 6.2 percent of the first $7,000 of income [source: IRS].

It's important to remember that all money an employer pays its employees is subject to payroll tax, not just standard salary, wages and tips. That includes vacation allowances, bonuses, commissions, back pay, sick pay, non-cash "in kind" payments (goods, lodging, food, clothing), tax-sheltered annuities, and fringe benefits like baseball tickets, country club memberships and discounted airline tickets [source: IRS].

As part of its payroll tax obligations, the employer must take all withheld funds and matching contributions and deposit the money in a bank or other financial institution authorized to receive federal tax funds [source: Business Owner's Toolkit]. Those deposits are made either monthly or semimonthly based on the amount of the money the employer withheld the previous year, known as the lookback period.

If you report $50,000 or less in withheld taxes during the lookback period (July 1 to June 30 of the previous year), you're a monthly depositor. If you report more, you're a semiweekly depositor. Deposits are usually made electronically through the Electronic Federal Tax Payment System, but can also be made by check. Since deposit dates carry strict deadlines and fines, many larger employers delegate this responsibility to a third-party payroll specialist.

To wrap things up, we'll discuss the federal tax obligations of people who are both employer and employee: the self-employed.

Self-Employment Tax

The self-employment tax is separate from income tax. A self-employed person pays income tax on his or her business earnings according to the IRS Tax Table for personal income. The self-employment tax covers the Social Security and Medicare contributions that aren't withheld from the taxpayer's earnings throughout the year.

A taxpayer is considered self-employed if he or she owns a business as a sole proprietor or independent contractor, or is the member of a partnership that runs a business [source: IRS]. You must pay self-employment taxes if you make more than $400 a year from non-church employment.

When we talked about payroll taxes, we mentioned that the employer is responsible for matching the employee's contributions to Social Security and Medicare. Since a self-employed person is both employee and employer, he or she must pay the full FICA taxes -- 15.3 percent of total income -- with no assistance. If a self-employed person earns more than $106,800, she uses a different calculation: 2.9 percent plus $13,243.20.

To pay self-employment tax, you either need a Social Security number or an individual taxpayer identification number (ITIN) for non-resident aliens. If you expect to owe more than $1,000 in self-employment tax, you're required to pay estimated taxes quarterly. You are penalized if you don't pay estimated taxes and wait to do it all at the end of the year. Self-employed workers can pay estimated taxes either by check or through the Electronic Federal Tax Payment System. If it's easier to pay the tax when you receive each check, you can pay monthly or even weekly, as long as the total adds up at the end of the quarter.

We hope this has been a helpful introduction to federal taxes. For lots more information and helpful tax-related links, head over to the next page.

Related HowStuffWorks Articles

Sources

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  • Business.gov. "Employment Taxes"http://www.business.gov/finance/taxes/employment.html
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