The income you receive from a job, business, inheritance, commissions, business earnings, or investments, is subject to be taxed by the federal government. Every person that receives income is required to annually file an income tax return to show their tax liability. The individual taxes we pay to the federal and state governments are used to fund education, defense, public services, social security, healthcare and many other things we use on a daily basis.
In the United States, income is taxed using a progressive tax method. The more you make, the higher a percentage of tax you will have to pay. The entire amount you make is not subject to the higher rate, just the amount above a threshold. These percentages and income amounts change year to year and are figured either, as an individual, as a head of household, or as a married couple.
To use general examples, let’s say you made 50k one year. The government might tax the whole 50k at a rate of 15 percent. This would leave you with a tax liability of $7,500 for the year. If you then make 100k another year, you would be taxed the same 15 percent on the first 50k or $7,500 but then for the next 50k your tax rate might be 18 percent or $9,000 making your total tax liability on the 100k $16,500. To take it one step further let’s say you made 150k. The first 50k you make is taxed at 15 percent or $7,500, the income over 50k is taxed at 18 percent or $9,000 and the income over 100k might be taxed at 20 percent which would be $10,000. This would make your total tax liability on 150k $26,500. These percentages and amounts are purely for illustrative purposes and do not reflect the current income tax rates or the amounts where the rates adjust.
The above example is based on zero deductions or credits. The Internal Revenue Service(IRS) has developed a complicated tax plan incorporating many different rules and regulations. These rules govern what income must be reported, and what exemptions, deductions, or credits can be used against this income to reduce your income tax liability.
Understanding the difference between deductions and credit
Let’s use the above example of 50k taxed at 15 percent. Without any deductions your total tax liability would be $7,500. Let’s say you had $2,000 in deductible healthcare costs and $3,000 in education expenses that is deductible. This would make your income that is calculated towards your tax liability equal $50,000- $2,000 – $3,000 = $45,000. 15 percent tax on $45,000 would be $6,750. As you can see your total tax liability without deductions as $7,500 but after deductions you are only required to pay $6,750.
This basic example shows the value of using as many deductions as are legally allowable under the current tax code. A Certified Public Accountant from North Star Tax and Accounting will make sure you are able to tax advantage of every deduction you qualify for. Contact us today to see how we can help.
Credits are calculated slightly different on your income taxes. Let’s us the same example of $50,000 with no deductions and 15 percent tax. Your starting tax liability is $7,500. A common credit is the child tax credit. Let say this credit is $2,500 for each of your children. In our example you are a family of Four so you have two children or a credit of $5,000. What this does is rather than reduce your income that is calculated for taxes, it is calculated against your tax bill. What this means is that you are still taxed based on $50,000 in income or $7,500 but your tax bill is reduced from $7,500 by the credit of $5,000 making your total tax bill only $2,500! As you can see tax credits have a much larger impact on your total tax liability than a tax deduction.
At North Star Tax and Accounting, our team of experts knows each and every tax credit the IRS allows and how to apply them. To see just how much we can help your tax situation, contact us today.
If you have any questions about filing your personal income taxes, request a free consultation with one of our tax professionals today. We will help guide you through the process to make sure you take advantage of every opportunity.