Taxes are complicated, stressful, and hard to predict- we get it. Tax code is so complicated, you have to be a law or math expert to make sense of it all. Millions of taxpayers were shocked to see their returns were much lower than they expected. About 90% of Americans don’t know how many tax brackets there are, let alone where they fit in.
How do tax returns work and how can you start to get out of the cloud of confusion surrounding taxes? Keep reading to find out.
Start With The Income Tax Brackets
If you read this section, you’ll immediately join the 10% of Americans who know how many tax brackets exist. You’ll also be able to tell where you fit in. Your tax bracket depends on your filing status, whether you’re single, head of household, married filing separately or jointly. The IRS just announced the new tax brackets for 2020. Here are the latest brackets if you’re filing as head of household.
- 10% $0 - $14,100
- 12% $14,100 - $53,700
- 22% $53,700 - $85,500
- 24% $85,500 - $163,300
- 32% $163,300 - $207,350
- 35% $207,350 - $518,400
- 37% $518,400 and above
This doesn’t mean that if you make $70,000 a year, you’ll be taxed at 22%. You have to take into account deductions to figure out what your taxable income truly is.
The important part to understand how tax returns work, is knowing what your AGI is. AGI stands for adjusted gross income. This is the number the IRS uses to figure out what tax bracket you fall under and how much you’ll owe in taxes. AGI is calculated by taking your gross income earned throughout the year, listed on your W-2 form.
This includes income from your job and any winnings, settled debts, and side-gigs over $600 each. For example, you earned $50,000 from your regular job, won the lottery for $2000, and had a side gig that brought in an additional $8,000. Your total earned income for the year is $60,000. Now, let’s lower that with some deductions.
On your 1040 form, you’ll have a few lines that ask for specific expenditures. You’ll be asked if you contributed to an IRA or 401(k). You’ll also be asked if you paid student loan interest, alimony, and paid into a Health Savings Account. If you’re self-employed, you’ll have your business deductions totaled here. You’ll need to fill out a Schedule C form with your 1040 that details your business income and business expenses.
All of these are considered to be above the line deductions. Your gross income will be subtracted from the total amount of above the line deductions. The result is your AGI.
The Standard Deduction
The income that you’re taxed on is your AGI subtracted by your deductions. You may take the standard deduction or itemize your deductions. Thanks to the Tax Cuts and Jobs Act, the standard deduction was doubled across the board. Most taxpayers will use the standard deduction to pay taxes. The standard deduction will depend once again on your filing status. Here’s how it looks for the 2020 tax year.
- Single: $12,400
- Married Filing Jointly: $24,800
- Married Filing Separately: $12,400
- Head of Household: $18,650
Subtract your AGI from the deduction and that will give you your taxable income.
How Do Tax Returns Work?
Now you have a general idea as to how much you should pay income taxes. Let’s do some math to figure out how much you’d pay in income taxes. Let’s say that you’re filing as head of household and you had an income of $60,000 a year. You had above the line deductions of $4,000, making your AGI $56,000. Now take the standard deduction, which would be $18,650.
Your total taxable income would be $37,350. That would put you in the 12% tax bracket. You would owe $4482 to the IRS in taxes for the year. Now, if you’re an employee, you’ll have taxes taken out of your paycheck. You’ll have paid taxes throughout the year. How much you pay largely depends on what you put on your W-4 form when you first started working for your employer.
The more allowances you take, the less money will be withheld for taxes. In this scenario, if you get paid every other week (26 times a year), you want to have $172.39 withheld from each paycheck for federal income taxes. That doesn’t count the amount you’d pay in state and FICA taxes. That’s only for federal income tax. If you have that much withheld, you won’t get a refund.
You won’t owe in April, either. You’ll just break even. What would happen if you paid $200 a paycheck in federal income taxes? That would total $5200. Subtract that by $4482 and you’d get a refund of $718. On the flip side, having only $140 withheld from your paycheck would mean you only paid $3640 in federal income taxes. You would owe the IRS $842.
What If You’re Self-Employed Or An Independent Contractor?
If you’re self-employed, you have more opportunities to lower your AGI in the form of business deductions. You may also be eligible for the 20% business pass-through deduction. This is where you can deduct 20% of your earnings from your taxes. Most businesses, even sole-proprietors can utilize this deduction.
The Self-Employment Tax
On the flip side, you’re going to be paying more in taxes because you have to pay 15.3% in self-employment taxes. The best thing that you can do to prepare for it, is to calculate your taxes throughout the year and set aside a percentage of your income just for taxes. If you expect to owe more than $1000 in taxes for the year, you will have to pay estimated quarterly taxes.
Understanding How Tax Returns Work
Taxes are complicated. How do tax returns work? You have to keep track of your deductions, all of your income, and make sure you pay enough during the year. The best thing you can do is to keep hold of your pay stubs so you know exactly how much you should set aside for taxes. Let's get you started. Choose a template of your liking and begin creating your paystub today with our paystub creator!