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The annual tax-filing ritual catches many people unprepared and still a bit uncertain of how the tax system actually works. The most important numbers you'll be working with are gross and net income, the latter being the amount that decides how much tax you have to pay. Before gross becomes net, there are some crucial calculations to make.
Gross income means everything you've earned, including wages, interest, dividends, capital gains, tips, rental income and so on. For most taxpayers, figuring out gross income is simply a matter of collecting W-2 and 1099 forms that show the amount and type of income earned in the past year. You can adjust your gross income by subtracting certain expenses, such as medical insurance if you're self-employed, moving expenses and contributions to an Individual Retirement Account (IRA). The result is the all-important adjusted gross income (AGI) number.
Getting to Net
The IRS does not apply its six different income tax rates (as of 2012) to gross income. Instead, you make further calculations to reach net taxable income. You take deductions for each member of the household, including yourself, that you're supporting. You can work out a standard deduction or itemize deductions on Schedule A. You also subtract exemptions -- an amount of your income that is not subject to income tax. The result, along with other adjustments to the AGI, is net income. Your tax rate depends on your net income; the higher the net, the higher the tax rate applied to it.
Most states have an income tax as well, for which you must prepare a return once a year. Many apply their tax rates to the AGI figured on your federal return and ask you to provide a copy of that return. Each state has its own set of tax rules that may allow you to take additional deductions from the taxable amount.
The IRS also collects payroll taxes to fund Social Security and Medicare. The rates are applied to your gross wages, in the amount of 4.2 percent for Social Security and 2.9 percent for Medicare (as of 2012). You don't pay on other income such as dividends or interest. The payroll rate is the same for everybody, but for Social Security tax purposes any gross income above $110,100 (in 2012) is exempt. Money you earn above that amount for the year is not subject to Social Security tax, although you continue to pay Medicare tax at the same rate. Your employer pays a 6.2 percent share of the Social Security tax; if you are self-employed you pay both employee and employer shares on money you earn on your own.
- tax forms image by Chad McDermott from Fotolia.com