4.2 Income Tax Terminology

J. Zachary Klingensmith

4.2 Income Tax Terminology

^[1]The U.S. government relies most on an income tax. The income tax is the most relevant for personal financial planning, as everyone has some sort of income over a lifetime. Most states model their tax systems on the federal model or base their tax rates on federally defined income.

Taxable Entities

There are four taxable entities in the federal system: the individual or family unit, the corporation, the nonprofit corporation, and the trust. Personal financial planning focuses on your decisions as an individual or family unit, but other tax entities can affect individual income. Corporate profit may be distributed to individuals as a dividend, for example, which then becomes the individual’s taxable income. Likewise, funds established for a specific purpose may distribute money to an individual that is taxable as individual income. A trust, for example, is a legal arrangement whereby control over property is transferred to a person or organization (the trustee) for the benefit of someone else (the beneficiary). If you were a beneficiary and received a distribution, that money would be taxable as individual income.

The definition of the taxable “individual” is determined by filing status:

Single, never married, widowed, or divorced
Married, in which case two adults file as one taxable “individual,” combining all taxable activities and incomes, deductions, exemptions, and credits
Married filing separately, in which case two married adults file as two separate taxable individuals, individually declaring and defining incomes, deductions, exemptions, and credits
Head-of-household, for a family of one adult with dependents

Some taxes are levied differently depending on filing status, following the assumption that family structure affects ability to pay taxes.

All taxable entities have to file a declaration of incomes and pay any tax obligations annually. Not everyone who files a return actually pays taxes, however. Individuals with low incomes and tax exempt, nonprofit corporations typically do not. All potential taxpayers nevertheless must declare income and show their obligations to the government. For the individual, that declaration is filed on Form 1040 (or, if your tax calculations are simple enough, Form 1040EZ).

Income

For individuals, the first step in the process is to calculate total income. Income may come from many sources, and each income must be calculated and declared. Some kinds of income have a separate form or schedule to show their more detailed calculations. The following schedules are the most common for reporting incomes separately by source.

Schedule B: Interest and Dividend Income
Schedule C: Business Income
Schedule SE: Self-Employment Tax
Schedule D: Capital Gains and Losses
Schedule E: Rental and Royalty Income; Income from Partnerships, S Corporations, and Trusts
Schedule F: Farm Income

Other Taxable and Nontaxable Income

Other taxable income includes alimony, state or local tax refunds, retirement fund distributions from individual retirement accounts (IRAs) and/or pensions, unemployment compensation, and a portion of Social Security benefits.

Your total income is then adjusted for items that the government feels should not be taxed under certain circumstances, such as certain expenses of educators, performing artists, and military reservists; savings in health savings or retirement accounts; moving expenses; a portion of self-employment taxes; student loan interest; tuition and educational fees; and alimony paid. Income that is not taxed by the U.S. government and does not have to be reported as income includes the following:

Welfare benefits
Interest from most municipal bonds
Most gifts
Most inheritance and bequests
Workers compensation
Veteran’s benefits
Federal tax refunds
Some scholarships and fellowships

It’s important to read tax filing instructions carefully, however, because not everything you’d think would qualify actually does. The government allows adjustments to be reported (or not reported) as income only under certain circumstances or up to certain income limits, and some adjustments require special forms.

The result of deducting adjustments from your total income is a calculation of your adjusted gross income (AGI). Your AGI is further adjusted by amounts that may be deducted or exempted from your taxable income and by amounts already credited to your tax obligations.

Deductions and Credits

Deductions reduce taxable income while credits reduce taxes. Deductions are tax breaks for incurring certain expenditures or living in certain circumstances that the government thinks you should not have to include in your taxable income. There are deductions for age and for blindness. For other deductions, there is a standard, lump-sum deduction that you can take, or you may choose to itemize your deductions, that is, detail each one separately and then calculate the total. If your itemized deductions are more than your standard deduction, it makes sense to itemize.

Other deductions involve financial choices that the government encourages by rewarding an extra incentive in the form of a tax break. Home mortgage interest is a deduction to encourage home ownership, for example; investment interest is a deduction to encourage investment, and charitable donations are deductions to encourage charitable giving.

Deductions are also created for expenditures that may be considered non-discretionary, such as medical and dental expenses, job-related expenses, or state and local income and property taxes. As with income adjustments, you have to read the instructions carefully, however, to know what expenditures qualify as deductions. Some deductions only qualify if they amount to more than a certain percentage of income, while others may be deducted regardless. Some deductions require an additional form to calculate specifics, such as unreimbursed employee or job-related expenses, charitable gifts not given in cash, investment interest, and some mortgage interest.

After deductions are subtracted from adjusted gross income, the remainder is your taxable income. Your tax is based on your taxable income, on a progressive scale. You may have additional taxes, such as self-employment tax, and you may be able to apply credits against your taxes, such as the earned income credit for lower-income taxpayers with children.

Deductions and credits are some of the more disputed areas of the tax code. Because of the depth of dispute about them, they tend to change more frequently than other areas of the tax code. As a taxpayer, you want to stay alert to changes that may be to your advantage or disadvantage. Usually, such changes are phased in and out gradually so you can include them in your financial planning process.

Payments and Refunds

Once you have calculated your tax obligation for the year, you can compare that to any taxes you have paid during the year and calculate the amount still owed or the amount to be refunded to you.

You pay taxes during the tax year by having them withheld from your paycheck if you earn income through wages, or by making quarterly estimated tax payments if you have other kinds of income. When you begin employment, you fill out a form (Form W-4) that determines the taxes to be withheld from your regular pay. You may adjust this amount, within limits, at any time. If you have both wages and other incomes, but your wage income is your primary source of income, you may be able to increase the taxes withheld from your wages to cover the taxes on your other income, and thus avoid having to make estimated payments. However, if your nonwage income is substantial, you will have to make estimated payments to avoid a penalty and/or interest.

The government requires that taxes are withheld or paid quarterly during the tax year because it uses tax revenues to finance its expenditures, so it needs a steady and predictable cash flow. Steady payments also greatly decrease the risk of taxes being noncollectable. State and local income taxes must also be paid during the tax year and are similarly withheld from wages or paid quarterly.

Besides income taxes, other taxes are withheld from your wages: payments for Social Security and Medicare. Social Security or the Federal Insurance Contributions Act (FICA) and Medicare are federal government programs. Social Security is insurance against loss of income due to retirement, disability, or loss of a spouse or parent. Individuals are eligible for benefits based on their own contributions—or their spouse’s or parents’—during their working lives, so technically, the Social Security payment withheld from your current wages is not a tax but a contribution to your own deferred income. Medicare finances health care for the elderly. Both programs were designed to provide minimal benefits to those no longer able to sell their labor in exchange for wage income. In fact, both Social Security and Medicare function as “pay-as-you-go” systems, so your contributions pay for benefits that current beneficiaries receive.

If you have paid more during the tax year than your actual obligation, then you are due a refund of the difference. You may have that amount directly deposited to a bank account, or the government will send you a check.

If you have paid less during the tax year than your actual obligation, then you will have to pay the difference (by check or credit card) and you may have to pay a penalty and/or interest, depending on the size of your payment.

The deadline for filing income tax returns and for paying any necessary amounts is April 15, following the end of the tax year on December 31. You may file to request an extension of that deadline to August 15. Should you miss a deadline without filing for an extension, you will owe penalties and interest, even if your actual tax obligation results in a refund. It really pays to get your return in on time.

Note: The following video discusses exemptions. Due to the tax code changes in 2017 there are no longer exemptions. Just ignore this, but realize they worked much like deductions.

Calculating Total Taxes

The United States uses a progressive tax system which is one where you pay a larger percentage of your income as you earn more income. The tax brackets for 2021 are shown below in Table 4.2.2.

Table 4.2.2: US Federal Income Tax Rates, 2021
Rate	Single	Joint	Head of Household
10%	Up to $9,950	Up to $19,900	Up to $14,200
12%	$9,951 to $40,525	$19,901 to $81,050	$14,201 to $54,200
22%	$40,526 to $86,375	$81,051 to $172,750	$54,201 to $86,350
24%	$86,376 to $164,925	$172,751 to $329,850	$86,351 to $164,900
32%	$164,926 to $209,425	$329,851 to $418,850	$164,901 to $209,400
35%	$209,426 to $523,600	$418,851 to $628,300	$209,401 to $523,600
37%	Over $523,600	Over $628,300	Over $523,600

The standard deduction for 2021 is

$12,550 for single filers.
$25,100 for married (filing jointly) filers.
$18,800 for head of household.

In the next section, we will use this information to see how income taxes are calculated.

Tax Payment Terms

One misunderstanding that people sometimes have is the belief that if they move up to the next tax bracket that their entire income will be subject to the higher tax rate. THIS IS FALSE! For example, for single filers, as we see in Table 4.2.2, income earned in the $9,951 to $40,525 bracket is taxed at 12%. So what if it is December 30th and you have earned $40,525. Your boss asks you to work an additional hour which would increase you annual income to $40,535, $10 into the 22% tax bracket. Does this mean that your entire income would now be taxed at 22%? NO! Only the final $10 is taxed at that rate. To help with this, I introduce a few terms.

From: https://en.wikipedia.org/wiki/Tax_rate

Statutory Tax Rate

A statutory tax rate is the legally imposed rate. An income tax could have multiple statutory rates for different income levels, where a sales tax may have a flat statutory rate.^[1]The statutory tax rate is expressed as a percentage and will always be higher than the effective tax rate.^[2]

Average/Effective Tax Rate

An average tax rate, also called the effective tax rate, is the ratio of the total amount of taxes paid to the total tax base (taxable income or spending), expressed as a percentage. If t is the total tax liability and i is total income, then the average tax rate is just t/i.

In a proportional tax, the tax rate is fixed and the average tax rate equals this tax rate. In case of tax brackets, commonly used for progressive taxes, the average tax rate increases as taxable income increases through tax brackets, asymptoting to the top tax rate. For example, consider a system with three tax brackets, 10%, 20%, and 30%, where the 10% rate applies to income from $1 to $10,000, the 20% rate applies to income from $10,001 to $20,000, and the 30% rate applies to all income above $20,000. Under this system, someone earning $25,000 would pay $1,000 for the first $10,000 of income (10%); $2,000 for the second $10,000 of income (20%); and $1,500 for the last $5,000 of income (30%). In total, they would pay $4,500, or an 18% average tax rate.

Marginal Tax Rate

A marginal tax rate is the tax rate on income set at a higher rate for incomes above a designated higher bracket, which in 2016 in the United States was $415,050. For annual income that was above the cut off point in that higher bracket, the marginal tax rate in 2016 was 39.6%. For income below the $415,050 cut off, the lower tax rate was 35% or less.^[3]^[4]

Marginal tax rates are applied to income in countries with progressive taxation schemes, with incremental increases in income taxed in progressively higher tax brackets, resulting in the tax burden being distributed amongst those who can most easily afford it.

Marginal taxes are valuable as they allow governments to generate revenue to fund social services in a way that only affects those who will be the least negatively affected.

With a flat tax, by comparison, all income is taxed at the same percentage, regardless of amount. An example is a sales tax where all purchases are taxed equally. A poll tax is a flat tax of a set dollar amount per person. The marginal tax in these scenarios would be zero, however, these are both forms of regressive taxation and place a higher tax burden on those who are least able to cope with it, and often results in an underfunded government leading to increased deficits.

When we do tax calculations in the next section, we will explore all of these concepts in more depth.

Adapted from 6.2 The U.S. Federal Income Tax Process in Personal Finance by Lumen Learning shared under a CC BY-NC-SA license. ↵

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