Let’s say you’re an incoming senior at state university who just finished a summer internship at a corporate office. Maybe you had a great experience and also made a lot of money. This is excellent news, but there is one problem. You have no idea how to pay your taxes, or even if the money you made requires you to do so, what should they do? Well, we’ve got you covered. Let’s start with the basics.
Tax Brackets Are Like Buckets
How does the US tax system work? Your Seattle CPA would say that taxes is a lot like filling up a line of progressively larger buckets. Each bucket corresponds to a specific tax rate, like 10%. Each bucket also corresponds to a particular income range, like $0 to $9,225. As your income grows, you fill up more and more of these buckets called brackets—each one with its tax rate. In addition to this, you’ll also need to pay what’s called a FICA tax. FICA is the flat tax on any money you’ve earned.
Sounds simple enough, right? Unfortunately, real life is a bit more complicated when it comes to taxes. Let’s use a more detailed example. Let’s say you made $30,000 last year. That’s your gross income. Gross income is how much money you made before taxes. This number can be refined at that point into what’s called AGI by subtracting certain expenses called adjustments. Adjustments are also known as above-the-line deductions. For example, if you paid $1,000 in combined student loan interest, your AGI would move from $30,000 to $29,000. taking a deduction.
Deductions depend on each tax payer’s expenses. So what does that even mean? There are several types of costs like charitable donations or mortgage interests that you can use to lower AGI. These are called itemized or below-the-line deductions. If you lack these specific expenses, you can instead take a standard deduction, a flat reduction in AGI. However, there is a catch. If you chose to take the standard deduction, you can’t also itemize your deductions. Be sure to pick the one that is greater.
The Standard Deduction Lowers AGI
Let’s assume you take the standard deduction. That means your AGI, currently sitting at $25,000, will be lowered to $18,700 (depending on the current standard deduction). That final number is your taxable income. Your taxable income is the amount of money eligible to be taxed by the IRS. If you plug that number into the tax brackets, you’ll find what you owe in federal income tax that year. Deductions, tax brackets, and tax rates can change year by year.
Considering that you started with $30,000 in gross income, this seems like a pretty good deal. However, there’s one more tool that you can use to save money. This last tool is called tax credits. Unlike exemptions and deductions, which lower AGI, tax credits directly lower your actual tax payments. For example, let’s say your eligible for a $1,000 tax credit. You can then use this credit to offset your tax bill, leaving you owing $1,000 less in income tax. Add to that the money for the FICA tax. This money will have already been automatically taken out of your paycheck by your employer.
So that’s the end of taxes. Well, not quite you may also have to supplement your federal taxes with state income taxes. Thankfully, however, these taxes are calculated very similarly to federal taxes and are almost always lower. Hopefully, you now better understand how taxes work.