The taxation system of the US and the tax laws that govern it are quite complicated and difficult to understand in one go. But it pays to be informed so that you can help your tax lawyer or advisor in creating a portfolio for you that helps you get the maximum tax benefits and credits possible within the tax laws. First of all, let it be clear that if you are a US citizen and are earning money by means of providing a service, doing a job or even by being self-employed, then you will have to pay income tax. It is applicable to all individuals and corporations on the basis of their financial income.
A Brief History Of Income Tax
During the earlier times of the US taxation system, income tax was not a prominent part. It was levied at some point then and on and off it was totally discarded from the system. But in the 16th amendment of the constitution that took place in 1913, income tax was made mandatory. It empowered the Congress to levy tax on any income, irrespective of the source. In addition to Federal income tax, most of the States too have income tax laws of their own.
Important Income Tax Terms
Let’s now understand some important terms in association with the income tax laws of the United States:
Gross Income: This means all income from all sources less any exclusion which may apply on that particular person’s income.
Adjusted Gross Income: This is the Gross Income less any ‘above the line’ deductions made on the income of an individual. These deductions are alimony, moving expenses, and trade or business deductions.
Taxable income: Taxable income for individuals is Adjusted Gross Income minus applicable standard deductions or itemized deductions, whichever is greater, and a deduction for any allowable personal exemptions for the taxpayer. Here the itemized deductions include any deductions such as a charitable contribution, certain medical expenses etc. Now this taxable income is multiplied by the appropriate tax rate to arrive at the tax due for the individual.
Tax credits: These credits are given to you after you file the tax returns. Tax credits like child tax credit, earned income tax credit are given without cutting any charges. This means that tax credits are more beneficial for you than the deductions because deductions are made before the tax rate, while credits are given afterwards. This means, if you are in the bracket of 30% tax rate, for $100 deduction, you would save only $30 of taxes, while for $100 credit, you save $100 worth of taxes.
Different Types Of Income For Tax Purpose
Income can be divided in a variety of ways while we are calculating taxes on it. Let’s understand about ordinary income and capital gains. By ordinary income, we mean compensation for personal services (read wages and salaries); profit from business, dividends from stock shares, interest from investments. Capital gains, as the name suggests, come from sale of investment property. The income tax on capital gains is lower than ordinary income, which shows the Government’s preference for long term investments.
There are further divisions in types of income and corresponding tax rates on the basis of short term and long term capital gains, qualified dividends and non-qualified dividends etc. When you hear someone referring to his/her tax rate, it simply means that they are talking about the marginal tax rates on their ordinary income.
If you are an individual filing your income tax, the marginal tax bracket that you will fall in depends upon your income and your tax filing classification. As of the year 2008, there are six classifications for filing your returns: Single, married filing separately, head of household, married filing jointly, qualified widow or qualified widower.
As you can see, there are many variations and classifications of the types of income, tax brackets etc., which makes the income tax laws of United States pretty complicated. But the above overview of the income tax law and major terms associated with it will definitely give you an edge when you are discussing about the income tax either with a tax lawyer or an accountant.