How Income Taxes Work

Filing Income Taxes

Filing income taxes in April is akin to "settling up" with the IRS. In reality, you've been paying taxes all year long. In April, all you are doing is determining if you paid the right amount. If you paid too much, you get a refund; too little and you're writing another check. Income tax forms like the 1040 are notoriously confusing, but that's because they're based on a U.S. tax code that's more than 5,000 pages long [source: Shinske]. Here are the basic steps to completing a tax return:

  1. Start by adding up your gross income, which includes salary or wages from a job, investment interest income, pensions and annuities. If you have job, your employer will send you a W-2 form in the mail which shows how much you earned and how much income tax was already withheld.
  2. Subtract any adjustments (examples: alimony that you paid, deposits in retirement plans, self-employment estimated taxes paid, moving expenses, interest that you paid on a student loan, etc.). The difference is called adjusted gross income (AGI).
  3. Once you know your AGI, you have two choices: Either subtract a standard deduction, or subtract itemized deductions, whichever is greater. Itemized deductions might include medical and dental expenses, charitable contributions, interest on home mortgages, and state and local taxes from the previous year.
  4. Next, subtract personal exemptions. For 2013, the IRS allows you to subtract $3,900 each for you, your spouse and each dependent if your AGI is under a certain amount [source: IRS]. Everything left over is called your taxable income.
  5. This is where it gets a little complicated, because the United States uses a marginal or progressive tax rate system. The more you earn, the higher your tax rate. To determine exactly how much you owe, look up your taxable income on the IRS tax table. Find the number that matches your filing status: single, married filing jointly, married filing separately, head of household, or qualifying widow(er) with dependent child, which is the same as "married filing jointly." That number is your gross tax liability. Don't worry, you have one more chance to lower your tax bill.
  6. From your gross tax liability, subtract any credits. The Child Tax Credit is a big one: $1,000 for each qualifying child. Other credits include the Earned Income Tax Credit (or Earned Income Credit) for low-income working families, which can be as much as $6,000, and the Child and Dependent Care Credit for childcare expenses.
  7. The final number is your net tax. If it's a positive number, you owe money to the IRS. If it's negative, you're getting a refund.

You must file your federal income tax return and pay any taxes owed by April 15. Filing or paying late results in penalties and interest that accrues over time. If you are due a refund, the IRS mails most of them out within two weeks of receiving a return. You could also have the money electronically deposited directly into a bank account.