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Tuesday, November 1, 2011

Ever wanted to know US how income taxes are calculated? -

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As a compliment to my last post about Corporate Taxes, this post will
be about how your personal income taxes are calculated. Most of us
just hand a shoebox full of pay stubs and receipts to an accountant,
go home, say a prayer and wait for them to conjure up some good news.
Want to know what's going on in the meantime? Then read on, brave

First off, you don't pay your federal taxes on tax day (April
15th). You actually pay your income tax little by little every time
you receive a pay check.

Look at your most recent pay stub. There's a line that says
"Federal Income Tax" and a dollar amount next to it. That amount has
been automatically deducted from your check by the IRS and moved into
a special account with your name on it (technically, your SS# is on
it). This happens every time you receive a pay check.

Once a year, the amount of income tax that you owe for that
year is taken out of your account all at once. Any money left over is
given back to you in the form of a check. That's your "tax rebate."

Ok, so how does the government figure out how much to take out
of the account? To calculate your tax bill, you need two different
sets of information: 1) the pertinent tax brackets and 2) the tax
rates that correspond to those brackets. You cannot calculate your
total bill without knowing both.

I feel like a lot of people hear "the $35,000 to $50,000
bracket has a 30% rate of taxation" and figure that means that if they
make between $35k and $50k, they just pay 30% of their total income in
taxes. This is completely incorrect!

What it actually means is that 30% of any income you are paid
that spans through the $35k and $50k interval will be surrendered as
taxes. The income below $35k is subject to taxation at a different
rate, and any income above $50k is subject to a yet another. Each
"bracket" has its own rate, and the taxpayer pays the particular
percentages of their income as it falls into those brackets.

Here's an example. Let's say we live in a country where there
are only two income tax brackets, and each bracket has its own unique

First bracket - $0 to $25,000. It has a 10% tax rate
Second bracket - $25,000 to $50,000. And it has a 20% tax rate

Now in this country we have a taxpayer named Mike. All year,
a portion each of Mike's paychecks has been automatically withheld by
the government and moved into an account for him. Now its income tax
season and the government is going to draw what Mike owes in income
tax from his account.

We'll say that Mike made exactly $30,000 over the course of the year.
So his income spans the entire first bracket (the "$0 to $25,000"
bracket), and just peeks into the second (i.e. he goes $5,000 over the
first bracket).

So right off the bat he pays 10% on that first $25,000 of his
income, for an initial hit of $2500 (25000*.10 = 2500).

But what about that extra $5,000? The bit that spills over
into the second bracket? Only the income that makes it into the
second bracket is taxed at the second bracket's rate. So Mike turns
over 20% of the $5,000 spillover, tacking an additional $1,000 on to
his bill (5000*.20 = 1000).

In the end, Mike's total tax bill comes out to be $3,500 (2500
+ 1000 = 3500). His total disposable income for the year would
therefore be $26,500. Earnings-Taxes = 30000-3500 = 26500.

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