Overview of the Federal Tax System

Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

Taxes always have been, and probably always will be, a hot button political issue. We'll mostly avoid getting into the politics of taxes today; instead, in this lesson we'll present an overview of the federal tax system and the IRS.

Some Fundamental Taxation Concepts

The U.S. federal tax system is based on a few key concepts. But before we can describe how taxes are administered and reviewed, we need to define a few important terms. Let's do that first.

  • IRS: shorthand for the Internal Revenue Service, which is the federal government agency responsible for administering, collecting, and auditing federal taxes.
  • Gross income: total income received by a tax payer during the tax period, usually a calendar year.
  • Deduction: an amount or percentage of income that is not taxed.
  • Taxable income: gross income minus applicable deductions.
  • Tax rate: the percentage of taxable income due to the IRS.
  • Tax bracket: ranges of taxable income, each with an associated tax rate.

The U.S. tax system is based on two basic ideas. First, that the more money someone makes, the more taxes they should pay, and second, that deductions can be used to influence taxpayers' behavior, such as going to college or buying a house.

Throughout the rest of this article, we'll look at John and Jane Jones, an average American household with the average household income of $50,500. The Jones's will be our example of the normal American household and how the federal tax system impacts them.

The Process of Calculating Taxes

We know the Jones's gross income is $50,500, but we need to find out what their taxable income is by subtracting deductions. When we know their taxable income, we can find their tax bracket, apply the associated rate, and see how much taxes they owe.

When it comes to deductions, every taxpayer has two choices. They can apply the standard deduction, which is an amount set by the IRS each year that taxpayers can automatically deduct from their gross income. Alternatively, they can look for as many other deductions as they can find to see if the total of the 'itemized' deductions is greater than the standard deduction.

For example, the standard deduction for the year the Jones's are calculating may be $12,600. That means they can just take the standard deduction and subtract the $12,600 from their gross income ($50,500 - $12,600), and end up with $37,900 in taxable income. Or they can look for itemized deductions, such as deductions for children, medical expenses, moving expenses (sometimes), educational expenses, and a lot of other things. For our purposes, let's just have them take the standard deduction.

So now we know that the Jones's have $37,900 in taxable income ($50,500 of gross income minus the standard deduction of $12,600). The lowest tax bracket has an upper limit of $9,225 and a rate of 10%. The second lowest tax bracket has an upper limit of $37,450 and a rate of 15%. The Jones's taxable income of $37,900 is in the third highest bracket, ranging from $37,450 - $90,750 with a rate of 25%, but they don't actually pay 25% on their entire taxable income.

Instead, the Jones's pay 10% on the first $9,225 of income, 15% on their remaining income up to $37,450, and 25% on their income up to $90,750. If we break that down, that's $922.50 in taxes for their first $9,225; $4,233.75 on their taxable income from $9,225 to $37,450 at the 15% rate; and 25% of the amount over $37,450, which for the Jones's is just 25% of $450, or $112.50. That means their total tax is 922.50 + 4,233.75 + 112.50 = $5,268.75.

Submitting Taxes

Most likely, John and Jane have been paying taxes throughout the year through some payroll withholdings. These are estimated taxes that are spread throughout the year, so when tax time comes John and Jane will have already paid either some of their taxes, all of their taxes, or maybe even extra taxes, which means they will get a refund.

When John and Jane look at the W-2 statements sent by their employers, they see they have had $7,000 of federal income taxes withheld from their checks throughout the year. On the appropriate IRS forms (in this case, a 1040-EZ), they report the $7,000 that they paid and the $5,268.75 that they owe. Subtracting what they owe from what they paid, they see they overpaid taxes by $1,731.25 ($7,000 - $5,268.75), which means the Jones's are getting a refund!

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