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How the Income Tax System Works [a Step-by-step Guide]



How Income Tax System WorksAs the name implies, with income tax, you are paying tax on your income—for example, your salary from a job or the interest on your savings account. However, you don’t have to pay income tax on all your income. That’s largely because not all income is considered taxable income. You would need to know how the income tax system works. The idea behind tax planning is to use all legal means available to keep your taxable income as low as possible. You probably don’t have $1 million to hide. In fact, you might be wondering whether tax planning isn’t just for rich people. The answer is “no”. People with modest incomes can benefit from tax planning. And they often can do it themselves, without high-priced accountants and tax pros.

This post shows you how income tax system works, in simple way, accompanied with case example. Enjoy!



To do this, you must go through a step-by-step calculation that will ultimately tell you how much you owe. Here are steps to calculate:


Step-1. Start With All Your Income

First, you add up all the income you earn or receive each year, regardless of the source—salary, interest, net business income, investment income, and anything else. If you’re married and file jointly, include your spouse’s income as well.


Step-2. All Income – Exclusions = Gross Income

Next, you get to exclude certain items from your income, to arrive at your gross income. These exclusions include such things as gifts, life insurance proceeds, up to $500,000 in profits from the sale of your home if certain requirements are met, interest earned on municipal bonds, and other items.


Step-3. Gross Income – Adjustments to Income = Adjusted Gross Income

Hey, more subtractions! You get to adjust your income downward for things like contributions to deductible IRAs and self-employed retirement plans, contributions to health savings accounts, your health insurance payments if you’re self-employed, moving expenses if you change jobs, and more. The resulting number is your “Adjusted Gross Income [AGI]”. (These adjustments are often called “above-the-line deductions”, because they go before the line for AGI on your tax return).

Step-4. Adjusted Gross Income – Deductions and Exemptions = Taxable Income

Now you can subtract out (1) any deductions you’re claiming, and (2) your tax exemptions. The result is your taxable income. You’ll choose between taking either a specified standard deduction or itemizing (listing) your deductions one by one. If you itemize, you can deduct expenses for such things as mortgage interest, state and local taxes, charitable contributions, and unreimbursed employee expenses. These are often called “below-the-line deductions” because they go after the AGI line on your tax return. Your exemptions consist of specified amounts you may deduct for yourself, your spouse, and your dependents (if any).

Step-5. Taxable Income × Tax Rates = Tax Liability

By multiplying the amount of your taxable income by the tax rates set forth in IRS tax tables or schedules, you’ll find out your tax liability. The tax rates vary according to the amount of your taxable income, from a low of 10% to a high of 35%.


Step-6. Tax Liability – Tax Credits = Tax Due

Wait, you’ve got one last chance to lower your tax bill. you can subtract any tax credits you’re entitled to, for such things as buying a hybrid car, paying for higher education or child care expenses, or making your home more energy efficient. The total remaining is the amount you owe the IRS.


Case Example: How to Calculate Income Tax

Ben and Annie are a married couple, with two young children, who file a joint income tax return. In 2009, Ben earned $70,000 in salary from his job, Annie earned $20,000 from a part-time home business and they earned $5,000 in interest income. Their total itemized deductions are $12,000, which exceeds their $10,900 standard deduction, making it worthwhile for them to itemize.

Here’s how they compute their taxes:

Total Income                                         = $  95,000
Minus: Exclusions to Income                = $           0
Gross Income                                        = $  95,000
Minus: Adjustments to Income             = $           0
Adjusted Gross Income                         = $  95,000
Minus: Itemized Deductions                 =  ($12,000)
Minus: Exemptions (4 × $3,500)           =  ($14,000)
Taxable Income                                     = $  69,000

Tax Liability [25% x $69,000]                = $    9,938
Minus: Tax Credits                                = ($         0)
Tax Due                                                 = $  9,938


How to Reduce Income Tax

Could Ben and Annie have reduced their income tax?


Here are just a few ways they could have reduced their tax:

  • Deferred taxes. The couple could have deferred part of their income taxes to future years by opening an IRA and contributing the $10,000 maximum. Annie could have put of collecting part of her business income until next year—$8,000 for example.
  • Taken advantage of tax credits. The family could have purchased a car, and shaved thousands of dollars of their tax bill.
  • Maximized tax deductions. Ben and Annie could have increased their tax deductions by making a $1,000 contribution to their favorite charity.


Had they done these things, here’s what Ben and Annie’s taxes would have looked like:

Total Income                                  = $87,000 (1)
Gross Income                                 = $87,000
Minus: Adjustments to Income      = ($10,000) (2)
Adjusted Gross Income                  =$77,000
Minus: Itemized Deductions          = ($13,000) (3)
Minus: Exemptions (4 × $3,500)   =  ($14,000)
Taxable Income                              = $50,000

Tax Liability  [15% x $50,000]        = $6,698
Minus: Tax Credits                         = ($2,000) (4)
Tax Due                                          = $4,698



(1)  $95,000 – $8,000 of deferred income

(2) IRA contribution

(3) $1,000 more for charitable contribution

(4) Vehicle purchase


Too bad Ben and Annie didn’t read this post. They could have paid $4,698 in taxes instead of $9,938.

There are many easy-to-understand ways to lower your taxes you can implement yourself—for example, opening an IRA or hiring your children to work in your business. Others are more complex and may require the help of a tax professional, such as tax-free exchanges of business property.

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