How does paying income taxes work in the US?

Question

I don't have a well defined idea on how the tax system works in the US, the few things I know is that they are paid to the IRS every amount of time (yearly probably) that there's an interest/additional fine after retarding a payment and there's a difference between active and passive income (e.g salary or bank interests, but I know whether there's a distinction in terms of percentage imposing). How does it work for a normal working layman that is, for example, an employee? How often should he pay the IRS? Does he have to pay each month a portion of his salary in taxes or does he have to gather the money on a yearly basis in order to have the fixed percentage of his annual reported salary (which is the sum of the 12 monthly salaries)?

Answer 1

Sources Of Income For Most People

Most people who have income (about 83% of them) earn their income entirely from wages and salaries and from financial investments (e.g. stocks, bonds, mutual funds, savings accounts, pension payments, etc.), and possibly from some other very simple sources of income that are treated the same way (like unemployment insurance payments).

(Most of the other 17% of people who have income have some rental real estate, or have a very simple self-employment situation where they are paid for their services and have very few kinds of expenses to report such a promotions workers or Uber drivers or barbers, which is complex, but not crushingly so.)

Wage and Salary Withholding

When you are hired as a wage or salary employee you have to fill out a form that gives the employer your Social Security number so that your income can be properly reported to the IRS and estimates how much tax should be withheld from your income. This is called a form W-4.

Every paycheck, some money is taken out of your paycheck for taxes. The main ones are federal income taxes, state income taxes, local income or "head" taxes, Social Security taxes, and Medicare taxes (Social Security and Medicare taxes combined are called FICA taxes). Sometimes there are other payroll taxes too like federal and state unemployment insurance taxes, but the dollar amounts involved in those taxes are tiny by comparison.

Local head taxes (imposed at a flat dollar rate per employee for working in a locality during a particular month), FICA taxes, and other payroll taxes are collected by an employer and are "final". There are no tax returns that you have to file for these taxes at the end of the year.

But federal, state and local income taxes involve withholding taxes deducted from each check, designed to approximate how much you will owe at the end of the year, and an annual tax return determining exactly how much you owe and settling up that amount with taxing authorities.

W-2s and 1099s (Information Returns)

At the end of the year, every employer that you received wages and salaries from gives you a form called a W-2 in quadruplicate. You attach one from each employer to every tax return you have to file (federal, state, local), and keep one for your records. Your W-2 summarizes how much income you made from that employer over the last year and how much of each kind of tax was taken out.

In order to do business with a financial company that could pay investment returns to you, you have to provide the company with your Social Security number on Form W-9, so that it can properly report your income to the IRS.

The financial companies that you have financial investments with send you are different form, called a 1099 every year, that summarizes how much interest and dividend income you received from that company over the last year.

The IRS gets copies of your W-2s and 1099s also, so that it is harder for you to cheat by not reporting income that they have already been told about.

Determining How Much You Owe On A Personal Tax Return In Simple Cases

Once a year, usually between April 15-17, depending upon weekends and holidays (there was special across the board extensions in 2020 and 2021 due to the pandemic), you have to file a personal income tax return called form 1040, and a state income tax return (more than one if you worked in more than one state during the year), and sometimes a local income tax return too.

On your tax return, you add up your wage and salary income from your W-2s and your investment income from your 1099s and add everything up. This is your "gross income."

Then you determine if you can take any deductions from your gross income. Deductions from gross income that you can take even if you can take the standard deduction (discussed below) are called adjustment to income (a.k.a. "above the line deductions") and give you your "adjusted gross income."

Everybody gets a very big deduction from their adjusted gross income that is called the "standard deduction", that is supposed to approximate deductible expenses while avoiding the record keeping involved.

But, if you have lots of certain kinds of expenses, like mortgage interest, charitable deductions, and certain out of pocket medical expenses, you can deduct the sum of these special personal expenses called "itemized deductions", instead of taking the standard deduction.

The forms to calculate certain kinds of tax deductions (called "schedules" to your tax return) are quite complicated.

Your adjusted gross income reduced by your standard eduction or your itemized deductions is called your "taxable income."

Once you know your taxable income, you can usually look at a chart to figure out how much tax you owe. The rates that apply are determined based upon your filing status (discussed below) as well as by the type of income involved.

If you have capital gains (e.g. from selling stocks at a profit) or qualified dividends (usually paid from stocks that you own and mutual funds that you own that invest in stocks), the tax calculation is more complicated, because different kinds of income are subject to different tax rates. But, if you have very high investment income, you pay an extra Obamacare tax as part of your income taxes on the amount of investment income you have over a certain dollar amount, although the overall tax rate on this investment income is usually still more favorable to the taxpayer than the income tax rate on wage and salary income.

This gives you the amount of "income tax" that you owe before credits and payments. Sometimes other taxes (like self-employment taxes) and penalties (like retirement early withdrawal taxes) are added to your income taxes for the total amount of taxes you owe.

But many people receive tax credits that reduce their income tax due dollar for dollar. Some of the more common reasons to receive a tax credit are having a child, paying for childcare, having a low earned income with almost no investment income (called the earned income tax credit), buying health insurance using an Obamacare marketplace rather than getting it from an employer or the government, overpaying your taxes in a previous year and carrying that forward to the current year, and having income taxes withheld from your wages and salaries.

The forms to calculate certain kinds of tax credits (also called "schedules" to your tax return) are also quite complicated.

For example, the Obamacare tax credit for health insurance purchased yourself from an Obamacare exchange, rather than by an employer or the government, is very complicated to calculate.

Some tax credits can't reduce your income tax below zero. Other tax credits and all tax payments are refundable and can cause you to receive a tax refund.

Your income tax due reduced by your tax credits (some of which are called payments), will leave you with either a tax refund, or a tax bill. The withholding tax system is designed to leave most people with a small tax refund.

Tax Rates And Filing Status

Federal income tax rates and income tax rates in some states that have income taxes are "progressive". The first bit of income is taxes at a lower rate and more income is taxed at a higher rate. There a several rates in all. The rate that you pay on your income depends upon your filing status.

Most married people file their taxes every year as a couple, rather than as individuals, although they can file separately if they wish. The tax rates on a married couple making a certain amount of income are often lower than (and not more than the same as) the tax rates on a single person with no dependents making the same amount of income. Married couples also get a bigger Standard Deduction than single people do.

Single people who have dependents have tax rates between those of married couples that file joint tax returns and those of single people without dependents. This is called "head of household" filing status.

Some business or entity taxpayers like trusts and corporations have their own tax rates. Other businesses called pass through entities just report to you what your share of the income of the trust or business was for the year, and tells you where to report it on your own tax return, usually using a form called Schedule K-1.

Tax Payments And Tax Returns

You have to pay the taxes you owe by the tax deadline for the year. And if you owe too much on that day, you also have to pay a penalty for not making quarterly estimated tax payments over the course of the year before the deadline. If you don't pay your taxes by the deadline you owe additional penalties and interest.

You don't necessary have to file your tax return by the tax deadline for the year. If you have paid enough taxes by the deadline you can usually get an extension of up to six months to file your actual tax return. But if you don't get an extension and file your tax return late, or if you get an extension and miss the extended deadline for filing your tax return, you pay a much bigger penalty.

Usually state and local income taxes use your federal income tax returns as a starting point, then make some state or local government specific adjustments to that number. State and local income taxes, as well as federal income taxes are withheld from employee paychecks and reconciled to the true amount owed at year end. The tax collection process for state and local income taxes is similar to the process for federal income taxes.

More Complicated Tax Returns

Taxes are much more complicated for people who are self-employed, or own their own businesses (at least in part, possibly with other co-owners), or who have investments other than simply financial account investments (e.g. rental property).

These people have to fill out detailed business tax returns showing business revenues, business expenses and business tax credits, in addition to the tax return that reports their wage and salary income (if any) and their financial investment income (if any), to reveal their business profits which are taxable income.

These business tax returns have to be prepared based upon raw bookkeeping information that the business keeps track of, rather than just getting an annual summary every year on a W-2 from an employer or a 1099 from a financial company. It can take many dozens of hours of work to prepare a business tax return for a year. Often, people hire professional tax preparers or accountants to help them do this (individuals hire tax preparers too, but the amount of work involved is trivial by comparison).

Self-employed people also have to pay a tax called the self-employment tax, which is a substitute for Social Security and Medicare taxes for self-employed people. And, since self-employed people don't have taxes withheld from their income as they earn it, they have to set aside money to make quarterly tax payments instead, and owe a penalty if they don't.

Businesses with employees also have to withhold money from the paychecks of their employees, and face swift and severe penalties from the IRS if they don't.

Businesses also have to withhold taxes from payments of taxable income made to people that will be hard for the U.S. to collect from, like people who don't live in the U.S. and aren't U.S. citizens.

What Discourages Cheating?

Self-employed people face a huge temptation to not report all of the income that they earn, or to claim deductions that they didn't actual pay for. There are two main ways that this is prevented from getting out of hand.

One is that certain kinds of payments made to self-employed people have to be reported to the IRS by the person making the payment (usually on form 1099).

The other is that the IRS "audits" a certain share of tax returns with the likelihood of an audit based upon a computer program that estimates the likelihood that you are cheating. The IRS also does simply audits that simply catch arithmetic errors on your tax forms and automatically corrects them without reviewing any documents that you send them.

If you are audited for something more complex than an arithmetic error on your tax forms, you have to provide bank statements, receipts, and other documents to the IRS to prove that the revenues and expenses that you reported on your tax return are accurate. It is basically, a slow motion mini-lawsuit.

The IRS has three year from when your tax return was due to do most kinds of audits, but can have up to six years if your tax return was grossly inaccurate, and has forever to audit you if you never file a tax return at all.

If an audit determines that you didn't pay or report all of the income taxes that you owe, you pay a significant money penalty. If the IRS proves that you intentionally cheated on your income taxes to defraud it, you can face higher penalties and you can also be prosecuted criminally for tax fraud.

What Happens If You Don't Pay Your Taxes?

If your tax return says that you owe income taxes and you don't pay them (or if the IRS determines based upon an audit that you owe more taxes than you paid and you don't successfully contest that determination in tax court), then the IRS sends you a notice that your tax payment is due.

If this doesn't get cleared up by a deadline, then the IRS can impose a tax lien upon you to take away your property (including financial accounts) and can take extra money out of your paychecks, while interest and penalties continue to grow.

These debts are harder to get rid of in bankruptcy than most kinds of regular debts owed to private individuals (e.g. credit card bills).

While there are lots of uncollected income taxes in the U.S., this is much less of a problem in the U.S. than it is in countries like Greece or Italy or Russia.

Overall Impact

Everybody who works as an employee pays significant FICA taxes (which are matched by their employers).

Most poor people and working class people either pay no federal income taxes or get refunds due to withholding that exceeds the taxes that they owe or due to refundable tax credits. Their tax returns are mostly pretty simple.

Most middle-middle class people who aren't self-employed pay a small amount of federal income tax from tax withholding, and get a small refund or owe a very small tax bill at the end of the year (usually less than 2$ of their annual income).

Upper middle class people who aren't self-employed like other people who aren't self-employed have fairly simple tax returns (despite more complicated schedules to claim special deductions and tax credits) and either get refunds or owe a very small tax bill at the end of the year. But, they pay significant net income taxes.

Very high income people and self-employed people who are at least middle-middle class have very complicated tax returns that involve a massive amount of effort in record keeping and at year end, and they pay very significant amounts of their income in income taxes.

But there is a cap on the maximum FICA tax and self-employment tax bill, and self-employed people can more easily structure their income to reduce the tax burden involved. Most big tax breaks are taken mostly by self-employed and high income people. So self-employed people and high income people often end up paying a smaller percentage of their actual income (at least at the margin by earning their last additional dollar of income) than upper middle class employees or lower income self-employed people.

Self-employed people and people with complicated investments also cheat on their taxes profoundly more often than employees do. Most self-employed people hate taxes (except for marijuana business owners who are thrilled to be legitimate and pay taxes rather than being criminals, even though they pay some of the highest tax rates of anyone).

While all federal taxes combined are slightly progressive overall (i.e. high income people pay more than low income people as a share of their income in federal taxes on average), combine state and local taxes are usually slightly regressive overall (i.e. the poor pay a higher share of their incomes in state and local taxes of all kinds that higher income people on average).

Combined federal, state and local taxes are overall roughly proportional to income on average, although very high income people pay taxes at lower rates proportionate to their incomes than the upper middle class, and a fair share of very low or no income people pay little or no taxes relative to their incomes.

Retail businesses (e.g. Wal-Mart) tend to pay exactly what you would expect them to pay under the tax laws. More complicated businesses, especially in the tech industry and multinational manufacturing companies, however, often pay far less income taxes than their revenues and financial accounting incomes would suggest, mostly due to industry specific tax credits and due to finding ways to shift income for tax purposes to tax shelter countries like Ireland or the Cayman Islands.

Also, the U.S. has shifted its mix of taxation from having a very large corporate income tax share to coming mostly from individual income taxes, over the past few decades.

Generally speaking, the U.S. income tax system favors investment income very strongly relative to wage and salary income, and, in big businesses, it favors debt financing relative to equity financing.

Other Taxes

Don't forget that income taxes aren't the only kinds of taxes. There are other kinds of federal, state and local taxes. The exact mix of taxes varies a lot from state to state and even from locality to locality within a state.

For example, a city with lots of shopping malls may rely more heavily on sales taxes, while a city that is mostly a bedroom community may rely more heavily on property taxes to pay its expenses.

Some states don't have personal income taxes but have taxes that look like income taxes that only businesses pay.

Real estate owners have to pay property taxes which are a percentage of the value of your real estate as determined by a local government official (and subject to protests through an administrative process). If you don't pay this, the property is foreclosed upon. Usually religious organizations, governments and charities are exempt from property taxes.

Vehicle owners have to pay registration fees and taxes every year based in part upon the value of the vehicle as determined by a government schedules based upon what you bought the vehicle for and when.

A few places charge sales taxes on the sale of real estate, but almost everyplace charges sales taxes on retail sales of things that you buy in stores (usually with exemptions for services and for groceries, but usually including retail sales of vehicles). Wholesale buyers who are buying things to resell them are usually exempt from sales taxes. Usually religious organizations, governments, and charities are exempt from sales taxes too.

There are also special sales taxes on retail sales (i.e. to a final customer who will use the goods rather than reselling them) for very specific kinds of items such as gasoline and diesel fuels, firearms, arrows, alcohol, and tobacco products. These are collectively called "excise taxes".

There are also taxes on certain imported goods called "customs duties" usually collected when they are imported.

Very large inheritances and lifetime gifts are subject to the federal gift, estate and generation skipping tax system. The cutoff is combined gifts and inheritances given of about $11.5 million per year per person per lifetime. Some smaller gifts and gifts to spouses and charities are exempt from this limit and can be made in addition to the lifetime limit. A few decades ago, gift and estate taxes were a much larger share of federal revenues.

The government also makes a little bit of money from leasing its own property (e.g. oil and gas rights and grazing rights), from user fees for things like parks and museums and getting government utilities set up, and from printing currency and coins. In oil rich countries, income from government property often eliminates the need to impose all or most taxes (notably the U.S. state of Alaska pays every citizen an annual check to share oil tax revenues). But this isn't true in most of the United States.

Most state and local governments have to break even every year from tax returns, with only small rainy day funds and limited access to debt financing that is highly regulated. But the federal government routinely runs deficit, spending more than it received in tax revenues and other revenues, which it finances with treasury bonds (which bear very low interest rates because the risk of default is so low).

Most state and local governments get a significant amount of money each year from other governments out of their tax collections and debt proceeds.

Answer 2

For convenience, you can have your employer withhold taxes from each pay check. You can also send money to the IRS quarterly.

The IRS prefers a steady predictable revenue stream and will fine you if you underestimated your income and make a balloon payment for the fourth quarter, even if the total amount you send them over the course of the year doesn't change.

State taxes work the same way. State taxes are deductible from Federal taxes, to an extent.