How Income Taxes Work

Taxes are a fact of life. We notice them from our very first paychecks to our very last and beyond. Let’s walk through specifically how income taxes work and how to file taxes and what it all means.

The federal government taxes income. Income here is very broadly defined, so keep in mind that any money you bring in could be potentially included in that definition and taxed. The key to understanding federal income taxes is that not all income is taxed equally. The US uses a bracketed income tax system, with different types of taxpayers (e.g. ‘Single’,  ‘Married Filing Jointly’, and a few others) using different bracket tables. 

Not all earned income is taxed equally.

Single is the filing status you typically use if it’s just you filing taxes; “Married Filing Jointly”, or “MFJ”, is the filing status you typically use if you’re married. The other filing statuses are ‘Married Filing Separately’, ‘Head of Household’, and ‘Qualifying Widow(er) with Dependent Child’, but we won’t go into them here.

Below are the different tables for single filers and ‘married filing jointly’ filers for tax year 2023.

Source: taxfoundation.org. These numbers are adjusted each year for inflation so make sure you get the most up-to-date numbers for the current year!

From the table, you might notice a few things. Any single filer that makes less than $11,000 or MFJ filers together making less than $22,000 is just taxed at a “flat” 10% rate, e.g. would owe up to $1,100 in taxes to the federal government that year. This is also true for those making more money than that - the first $11,000 that you make is taxed at 10%. If a single filer makes $25,000 in a year, only $14,000 of that money (or $25,000 minus $11,000) is taxed at the next tax bracket up, or 12%; the first $11,000 is still just taxed at 10%. An illustration for another single filer who makes $100,000 in a year:

Example Breakdown of Tax Brackets for a $100,000 earner whose filing status is “Single”.

Note that this $100,000 earner “fills up” the full 22% tax bracket, but is partway through the 24% tax bracket. The 24% tax bracket is this earners “top tax rate”. Your top tax rate is called your marginal tax rate. The is essentially the most expensive dollar of income you’re earning. This is not your average tax rate, also known as your effective tax rate. You cannot just take your annual income and divide by the top tax rate you’re in - that will lead you to falsely believe that you are paying more taxes than you actually are. (For this $100,000 earner, $17,400 is much less than $100,000*24%, or $24,000. $17,400 results in an average tax rate of 17.4% for this taxpayer.)

Your marginal tax rate is different than your effective tax rate!

Note: I’m only talking about income taxes here on ordinary income (e.g. from your employer). I’m not talking about capital gains taxes, payroll taxes like Social Security or Medicare, or anything else for the moment. (More to come.)

Moving to states for a moment - states have their own rules on income taxes. Some states like California use a progressive bracket system like the federal government; some states like Illinois charge a flat % income tax on all income. You can look up the rules in your state and compare them to what’s on your paystub.

On filing

You can imagine that it might be a huge logistical nightmare if no federal/state income taxes were withheld from anyone’s paycheck throughout the year, and everyone owed fairly large sums of money to the government just once per year. To solve this problem, most employers withhold tax automatically from your paystub based on what you tell them when you’re hired via the W-4 form. If you’re self-employed or have large side businesses, you may also pay estimated taxes each quarter.

Then each year by April 15th - you actually file your taxes, by which I mean you settle up with the government and state how much you actually made in the prior year and what you actually owe compared to how much you’ve already paid via withholding and/or estimated tax payments.

All of the forms you get starting in January before the April 15th filing/reconciliation deadline - the W-2 form from your employer, a 1099 from your brokerage accounts, another from your savings accounts, and so on - are all informational and are meant to help you add up all of your income for the year and your taxes that you’ve paid so far. 

The forms you get in the mail are informational; you compile that information and send it to the government via the 1040 form. This is what “filing” taxes means.

Your job is to aggregate all of this information and fill out the 1040 form (or something similar) based on the information. This 1040 form is then what you send to the government to “reconcile” - getting your tax refund soon after or sending in any additional tax you owe.

A few suggestions:

Part of the strategy in personal finance is to spread out your income over the years to make that top tax rate as small as possible (e.g. contributing to a pre-tax 401(k) plan during a high-income year when you’re in a high top tax bracket, or using a low-income year when you go back to school/take time off to pay taxes on some of that pre-tax money by converting it to a Roth since you’re in a lower income tax bracket).

Large tax refunds are not the goal.

Tax refunds are not always a good thing! If you are getting a big chunk of money back from the government each year, it means that you have not had access to your own hard-earned money for that whole year. You’ve essentially given the government an interest-free loan. Make sure you optimize your estimated tax payments and/or employer withholding to balance out to only get a little back or only owe a little more when you reconcile in April.

Need help figuring out how much to ask your employer to withhold or if you need to consider paying estimated taxes? Reach out to Sarah today for a free, no-obligation intro chat here!

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