Taxes Made Easy: Everything You Need to Know (and Avoid)

Here is an overview of how taxes work in the US – from tax withholdings to filing by April 15^th. This will help you understand how much you’ve paid and why you’re either receiving a refund or owing additional taxes.

Today, October 22, 2024, the IRS announced new federal income tax brackets for 2025. Here’s the Inflation-Adjusted Tax Brackets for 2025:

Personal Income Taxes Basics

First and foremost – Tax rates are applied to incremental brackets — they are NOT applied to your overall taxable income. Only the portion that exceeds the previous bracket’s threshold is taxed at the higher rate. Everyone pays the same amount of tax on income within each bracket. This structure is known as a “progressive tax system.” Here are two examples:

Assume an individual is single and “moves up” in tax brackets from 10% to 12% as their income increases from $11,925 to $30,000. The 12% tax rate applies only to the incremental taxable income of $18,075 ($30,000 - $11,925).

Notice that the overall tax rate is lower than the highest marginal tax rate (beyond the first tax bracket). This will always be the case, though it can be harder to see at extremely high income levels.

How Individual Income Taxes Work in the US

In its simplest form, you fill out a W-4 form when you start a new job to determine how much federal income tax your employer withholds from each paycheck, typically issued every 2 weeks.

You must file your taxes by the April 15^th deadline each year to reconcile what you’ve already paid and what you owe for the previous tax year. If you receive a refund, it means you overpaid. If you owe additional taxes, penalties may apply.

A refund is not free money from the government. It simply means you gave the government an interest-free loan, and they are returning what you overpaid. On the other hand, if you owe money to the government, several penalties may apply (subject to change, with possible waivers):

• Failure-to-pay penalty: 0.5% per month, up to 25%
• Failure-to-file penalty: 5% per month, up to 25%
• Interest: Based on the federal short-term rate plus 3%, compounded daily, which is currently 8% for underpayments this quarter

Yes, this may seem unfair, but it’s how our system works. Clearly, it’s better to receive a refund by estimating and paying enough throughout the year than to face a large bill by the April 15^th deadline.

Tax Deadline

The tax deadline for filing individual income tax returns in the US is typically April 15^th. However, if April 15^th falls on a weekend or holiday, the deadline is moved to the next business day.

You can request an extension, usually moving the filing deadline to October 15^th. Extensions are helpful for those waiting on late tax forms (such as Schedule K-1s) or needing more time. However, any taxes owed are still due by the original April deadline to avoid penalties and interest.

How to “Do” Your Taxes

This is the basic process for how individual income taxes work in the US.

1. Calculate your taxable income
   • Gross income: Includes wages, salaries, bonuses, investment income, rental income, and other income sources.
   • Deductions and adjustments: Subtract pre-tax deductions like contributions to pre-tax retirement accounts (401(k)s & IRAs) or student loan interest, etc. The results in your adjusted gross income (AGI).
   • Exemptions and Standard/Itemized Deductions: Use either the standard deduction (a fixed dollar amount not subject to tax) or itemized deductions (qualifying expenses such as mortgage interest, capped at certain limits). Itemizing is less common since the 2017 Tax Cuts and Jobs Act significantly increased the standard deduction. The result is your taxable income.
2. Calculate taxes owed based on progressive tax rates
   • Apply incremental tax rates to each portion or “slice” of your taxable income.
3. Apply tax credits
   • After calculating your taxes, apply any tax credits, which reduce your tax bill dollar-for-dollar.
4. Compare taxes owed versus taxes already paid
   • Taxes Owed: This is the amount you calculated based on your taxable income.
     Taxes Already Paid: Includes withholding (taxes taken from each paycheck) and estimated payments (for self-employed individuals via Form 1040-ES).
   • If you paid more than you owe, you’ll receive a refund. If you underpaid, you’ll owe the difference when filing your return.
5. Repeat for state and local taxes
   • State and local taxes follow a similar structure to federal taxes, with progressive rates and standard deductions.
   • Some cities (e.g. New York City) impose income taxes in addition to state taxes.
6. File your return
   • Use Form 1040 (Federal) to file your federal return. Each state will have its own form for filing state income taxes.
   • Attach any necessary schedules. (e.g. Schedule E for rental income, 1099-G for unemployment income, etc).

Important takeaway: Tax credits are more valuable than tax deductions. Tax credits reduce your tax liability dollar-for-dollar, whereas deductions lower your taxable income. In general, the value of a deduction is equal to the deduction amount multiplied by your marginal tax rate.

What Changes Every Year

Why do tax brackets change annually? The main reason is to account for inflation. These adjustments prevent “bracket creep,” which occurs when inflation pushes taxpayers into higher tax brackets without an increase in real purchasing power.

Here are other annual updates, most of which are adjusted for inflation:

• The standard deduction: The flat amount taxpayers can deduct from taxable income if they don’t itemize deductions.
• Tax credits and deductions
  • Examples: Earned Income Tax Credit, Child Tax Credit, etc.
• Capital gains tax brackets
  • Long-term capital gains (for investments held over a year) are taxed at different rates, with income thresholds adjusted yearly.
• Contribution limits for retirement and other accounts
  • IRAs, 401(k)s, Health Savings Accounts (HSAs), etc.
• Estate and gift tax exemptions
  • The amount of wealth that can be transferred tax-free during one’s lifetime or at death (estate tax).
• Alternative Minimum Tax (AMT) exemption amount: Adjusted each year to limit AMT exposure
• Personal exemption
  • Eliminated by the 2017 Tax Cuts and Jobs Act but could be reinstated in future tax reforms (Election coming Nov 2024!).

I hope this overview helps clarify the tax process. My goal is to provide useful information to my community. Please note that I am not a tax accountant or tax attorney, and this content does not constitute tax advice. For personalized guidance, consult a qualified tax professional.

Cheers,

Yang