Income Tax 101
This page provides a quick overview of the U.S. federal income
Here's a quick overview of the U.S. federal income tax:
Figuring your income tax involves four steps:
- Find your total income.
- Subtract your deductions: the result is your taxable
- Apply the tax rates to find your tax.
- Subtract your withholding and other payments and
credits: the result is the tax you owe, or the refund you have coming.
Step 1: Total Income
Total income includes many kinds of receipts: wages, interest, dividends, business and
partnership income, amounts you receive from IRAs and pension plans, alimony, lottery
winnings and the list goes on. Of special interest: it includes your profit from
sales of assets such as stock or real property in other words, capital gain.
But some items aren't included. For example, total income doesn't include gifts you
receive or life insurance proceeds.
Step 2: Deductions
Deductions come in four main flavors:
These deductions are claimed as part of the calculation of business income, so they're
actually part of the determination of total income in Step One. But take note: deductions
related to your investment activities are not considered business deductions.
These are deductions you're allowed to claim even if you don't claim itemized
deductions (see below). Among the items here are your contributions to an IRA or
Keogh plan, and alimony you paid. When you subtract your adjustments from total income,
you arrive at an important number called adjusted gross income.
For a single
filer in 2004 (not blind or over age 65) the standard deduction is
Each year you're allowed to claim itemized deductions or the standard
deduction, whichever is larger. Itemized deductions include such items as medical
expenses, state and local taxes, mortgage interest and investment expenses. If
those items don't add up to a large enough total, you claim the standard deduction
instead. Your standard deduction depends on your filing status and is adjusted each year
for inflation. Most people find that the standard deduction is larger than the total of
their itemized deductions. As your income grows, you're likely to see your itemized
deductions grow also. When they become large enough, you should claim itemized deductions
instead of the standard deduction.
exemption amount for 2004 is $3,100.
You're allowed a deduction just for being you: a personal exemption. You're also
allowed an exemption for each person who qualifies as your dependent. Like the
standard deduction, the exemption deduction is adjusted each year for inflation.
When you've subtracted all of these deductions from your total income, the result is
your taxable income.
Step 3: Apply the Tax Rates
Once you know your taxable income, you apply the tax rates to find out your tax. Most
people do this quite simply by looking up their taxable income in a table supplied with
their tax form. If your income includes long-term capital gain you have to perform a
special calculation to obtain the benefit of the lower rate that applies to this type of
Step 4: Subtract Payments and
reduces your taxable income; a credit directly reduces your tax.
The tax law allows you to claim certain credits that reduce the amount of tax
you owe. For example, if you pay for child care, a portion of that expense may be allowed
as a credit. And of course, you get credit for any tax you've already paid
including income tax your employer withheld from your paycheck and any estimated tax
payments you made during the year. Subtract your credits and payments from your tax to
find out how much you owe. If your payments exceed the tax, you're in luck: you have a