Personal Taxes: The Basics

Read On for a Personal Tax Primer.

Taxes are a means of raising revenue for services provided by the state. The main taxes in the USA are income tax, sales tax, capital gains tax and payroll taxes. There are also many other smaller taxes such as tariffs and sin taxes.

The federal government receives most of its money from income tax through individual citizens and corporations. States may also receive money from income tax, but the majority of their revenue is generated by sales tax.

Income Tax

Individuals are subject to taxation through income tax on all worldwide income which includes investment income, self-employment earnings and wages. The same rate applies to all individuals regardless of what they earn because there are personal allowances for individuals who earn below a certain amount. This means that those individuals do not have to pay any income tax on their earnings from above this threshold.

Income tax is calculated as a percentage of taxable income for the year, subtracting all relevant allowances and deductions from the total amount of taxable income. The marginal rate of tax is the percentage that applies to an individual's income, so it depends on how much money they earn. It is possible to calculate the amount of tax payable for an individual by using a tax calculator or using online software such as Ready Reckoner .

Corporations are subject to taxation through income tax at the federal level and taxes equivalent to corporation tax in most states. The majority of dividends paid out to corporate shareholders are tax-free. However, some dividends may be subject to a personal income tax rate in the hands of individuals depending on their total income.

Capital Gains Tax

The capital gains tax is a percentage which is applied to the increase in value of capital assets between purchase and sale or disposal. Special rules apply to some assets, especially for individuals. For example, the capital gains tax is zero for taxpayers up to $250,000 of net capital gain income if married filing jointly or $125,000 if single.

Capital gains tax rates are determined by the length of time an asset is owned by an individual. If someone has held onto an asset they bought and sold within a year, then they will be subject to capital gains tax as if it were a sale price minus the cost of purchasing the asset. If an individual has held onto an asset for over a year, then their gain is taxed at lower rates depending on whether the capital gains were short term or long term (over 1 year).

Capital gains tax rates work differently for corporations which are not subject to capital gains tax at the federal level. It is possible for a corporation to use the mark-to-market method to account for unrealized gains on securities because interest rate fluctuations can affect their value substantially within one financial year. This means that corporations may be required to pay capital gains tax at the end of a financial year when they have appreciated in value, even if they have not been sold.

Capital gains can also be deferred by corporations through a sale-leaseback arrangement which allows them to sell assets and lease them back from a third party for an extended period of time. The corporation therefore avoids paying capital gains tax because it has simply transferred ownership of the asset to a third party temporarily.

Payroll Taxes

Employee social insurance is a federal program which requires employees to pay a certain percentage of their gross income as payroll tax. Employees must also pay half of their employer's contribution as payroll tax. Employers are responsible for withholding and remitting these amounts from employees' paychecks, and they must themselves make contributions to the federal government by submitting a W-2 form each calendar year.

Social Security tax applies to employees up to an annual wage ceiling after which no further payroll tax is withheld by employers. The base amount of payroll tax withheld from an employee's paycheck is 6.2% for both employer and employee, and the ceiling amount is 7.65%. The amount of taxable income over the annual threshold where payroll tax stops being withheld depends on factors such as total income and filing status.

Self-Employed Contributions

The amount a self-employed person must contribute to worker's compensation insurance depends on their average income for previous years. Self-employed individuals are required to pay the equivalent of unemployment insurance tax as worker's compensation insurance. The self-employed must also pay federal income tax on their business earnings including income for worker's compensation insurance.

Tax Deductions  / Tax Exemptions

Tax deductions reduce taxable income and therefore have a direct impact on an individual or corporation's total tax bill. Tax deductions are claimed on the income tax return every year to reduce total income, and therefore reduce the amount of income tax owed by an individual or corporation.

Corporations are subject to corporate taxes on their taxable profits, but they can claim some deductions before arriving at their taxable profit figure. These deductions are known as "above-the-line deductions" because they reduce the taxable amount without affecting the corporation's total income. For example, interest on business loans is deductible from a corporation's gross income.

Other deductions are only claimable once a corporation has already arrived at its taxable profit figure. These deductions include state and local taxes paid by a corporation which pay them directly to local, state or foreign governments.

Tax credits are deducted directly from an individual's tax bill. They reduce taxable income by the amount used to calculate the credit which means that taxpayers will save money on their taxes if the credit cancels out all or part of their tax liability. For example, workers who rely on public transportation to get to work can claim a tax credit for the cost of their commute each year.

Tax credits are often more advantageous to corporations than deductions because they can reduce taxable income below zero and therefore completely eliminate a corporation's federal tax bill. For example, some companies may be able to use a R&D tax credit to offset all of their annual taxes owed.

Retirement Savings Contribution Credit

Some individuals are entitled to claim a tax credit based on the amount saved for retirement in certain types of accounts. For example, taxpayers may claim a retirement savings contribution tax credit if they contribute to an Individual Retirement Arrangement (IRA) or other account which is eligible for this type of credit. Contributions must be made in the tax year in which individuals are claiming the credit.

Earned Income Tax Credit

Individuals with low to moderate income may be entitled to claim an earned income tax credit on their federal or state income tax return. This is a refundable credit for taxpayers who have no federal income tax liability, and it can therefore give taxpayers a refund of the total amount of their credit. To claim the credit, individuals must meet certain criteria including having no federal income tax liability, and having earned income (such as salary) of less than a certain amount.

Tax Credits for Higher Education

The American Opportunity Credit is available to recent high school graduates who are attending college on at least a part-time basis. It is available to a maximum of four years college per student, but it can be claimed for no more than two tax years per beneficiary. This means that the credit is limited to $2,500 per student per year.

The Lifetime Learning Credit is available to any taxpayer who is attending an eligible education institution on at least a part-time basis. It is available to a maximum of 20 years per beneficiary, which means that the credit can be claimed for multiple years as long as the taxpayer continues to attend college or other institution on at least part-time basis. This credit does not have an upper limit on the number of tax years it can be claimed for each individual because there are no restrictions on the number of years it can be claimed by each student.

American Opportunity Credit and Lifetime Learning Credit

To be eligible for either of these credits, students must attend an institution which is eligible to receive federal financial aid funds. This means that most public or private universities or colleges are eligible, but it also includes vocational schools, junior colleges, and graduate schools.

Elderly or Disabled Credits

Some taxpayers may be entitled to claim a credit for a relative who is elderly or disabled. To claim the credit, the taxpayer must have supported their relative in the tax year in question, and their income must not have been above a certain limit. For example, individuals may only be able to claim an elderly credit for a spouse who is 65 or older, and taxpayers cannot have claimed any dependents other than their spouse.

Special rules may apply if a taxpayer is filing as head of household, as a qualifying widow or widower with dependent child, or as married filing separately.

Head of Household and Filing Status Rules

Individuals who are not married and support a child who lives with them more than half the time can claim an exemption for their child on their tax return. The child does not need to be the filer's own child, but the filer must list the other parent's information on their tax return if they are married and living with their spouse, or provide the name and taxpayer identification number (TIN) for any other non-spouse who is claiming the exemption.

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