Taxes

Gross Income

This includes all income received from all sources, and could include money, property, and the value of services received. Gross income is reduced by adjustments and deductions before taxes are calculated. Wages, tips, interest, dividends, rents and pension income are examples of sources that contribute to your gross income.

Understanding the Marginal Tax Rate

Under a marginal tax rate, taxpayers are most often divided into tax tax brackets or ranges, which determine the rate applied to the taxable income of the tax filer. As income increases, what is earned will be taxed at a higher rate than the first dollar earned. In other words, the first dollar earned will be taxed at the rate for the lowest tax bracket, the last dollar earned will be taxed at the rate of the highest bracket for that total income, and all the money in between is taxed at the rate for the range into which it falls.

wage base limit

is the maximum wage that's subject to the tax for that year. For earnings in 2020, this base is $137,700. Refer to "What's New" in Publication 15 for the current wage limit for social security wages; or Publication 51 for agricultural employers

Modified Adjusted Gross Income (MAGI)

This is your AGI plus a few adjustments added back in. Your Modified Adjusted Gross Income determines your eligibility for certain deductions, credits and retirement plans. Take note: there's no fixed definition of MAGI as the adjustments vary, depending on the specific tax benefit.

What Is the Marginal Tax Rate?

is the tax rate you pay on an additional dollar of income. In the United States, the federal marginal tax rate for an individual increases as income rises. This method of taxation, known as progressive taxation, aims to tax individuals based upon their earnings, with low-income earners being taxed at a lower rate than higher-income earners. KEY TAKEAWAYS The marginal tax rate is the tax rate paid on the next dollar of income. Under the progressive income tax method used for federal income tax in the United States, the marginal tax rate increases as income increases. Marginal tax rates are separated by income levels into seven tax brackets.

break down the percentage by Social Security and Medicare.

Social Security tax is 6.2%. There is a Social Security wage base limit, so you only need to withhold up to a certain amount. Medicare tax is 1.45%. Unlike Social Security tax, there is no Medicare wage base limit. Instead, there is an additional Medicare tax. After an employee earns above the additional Medicare tax threshold, withhold an additional 0.9% of their wages. That means you will withhold 2.35% for Medicare with the additional tax (0.9% + 1.45%). However, you only contribute 1.45%. You're probably wondering — what is the purpose of payroll taxes exactly? Again, payroll taxes fund Social Security and Medicare programs. This includes retirement, disability, health care, hospice care, and survivor of deceased worker benefits.

What is a Tax Deduction?

Tax deduction lowers a person's tax liability by reducing their taxable income Because a deduction lowers your taxable income, it lowers the amount of tax you owe, but by decreasing your taxable income — not by directly lowering your tax. The benefit of a tax deduction depends on your tax rate. Here are some commonly overlooked tax deductions.

Income tax

is made up of federal, state, and local income taxes. Unless exempt, every employee pays federal income tax. Most states have an additional state income tax. Some localities also have a local income tax. Income tax amounts are based on a number of factors, such as an employee's Form W-4 and filing status.

What is payroll tax?

Payroll tax uses a flat tax rate, meaning it is a percentage that you withhold from employee wages. Withhold 7.65% of each employee's gross wages from their pay. And, contribute a matching 7.65%. So, if an employee earns $500 per paycheck, you would withhold $38.25 ($500 X .0765) from their paycheck. You also need to contribute $38.25 for the employer portion.

What is a Tax Credit?

A tax credit is a dollar-for-dollar reduction of the income tax owed. A tax credit directly decreases the amount of tax you owe . Common credits include the Earned Income Credit, American Opportunity Tax Credit, and the Savers Tax Credit. A credit can be nonrefundable or refundable. A nonrefundable credit lets you reduce your tax liability to zero (0). A refundable credit can also reduce your liability to zero (0) but there is an added benefit. If there's any amount leftover from your refundable credit after reducing your tax to zero, you get the balance of the credit back as a refund. The Earned Income Tax Credit (EITC) is an example of a refundable credit.

What Is Adjusted Gross Income? What Is AGI?

Adjusted Gross Income is simply your total gross income minus specific deductions. Additionally, your Adjusted Gross Income is the starting point for calculating your taxes and determining your eligibility for certain tax credits and deductions that you can use to help you lower your overall tax bill. Adjusted Gross Income, or AGI, starts with your gross income, and is then reduced by certain "above the line" deductions. Some common examples of deductions that reduce adjusted gross income include 401(k) contributions, health savings account contributions and educator expenses.

The Difference Between Tax Credit and Tax Deduction - An Example

Say, for example, that you or one of your dependents is in college. There are several options to get a credit or a deduction for tuition paid. Tuition of $10,000 can reduce your total tax up to $2,500 using the American opportunity credit, which can reduce your total taxes due up to $2,500. The American opportunity credit is partially refundable, so even if you don't owe any tax, you could receive a refund of up to $1,000. Another credit option for education expenses is the lifetime learning credit. This credit can result in a reduction in tax up to $2,000. The lifetime learning credit is nonrefundable, so if you don't have any taxable income or your tax liability is reduced to zero, it would not create a refund. Taxpayers could also choose the tuition and fees deduction, which can reduce your taxable income by up to $4,000. If you're in the 22% tax bracket, a $4,000 deduction lowers your taxes by $880. A deduction can only lower your taxable income and the tax rate that is used to calculate your tax. This can result in a larger refund of your withholding. A credit reduces your tax giving you a larger refund of your withholding, but certain tax credits can give you a refund even if you have no withholding.

Marginal Tax Rate vs. Flat Tax Rate

The other type of tax rate is the flat tax rate, which a few states implement for state income tax. Under this system of taxation, people aren't taxed on a scale (like the marginal tax rate), but rather, flat across the board. In other words, everyone is charged the same rate, regardless of income level. Most systems that use a flat tax rate do not allow for deductions and are seen in countries with a rising economy. Those who support this system of taxation describe it as fair, as it taxes all people and businesses at the same rate. Those who oppose it believe that it results in high-income taxpayers paying less than they should for an equitable society.

Taxable Income

This is your AGI minus either the standard deduction or total of itemized deductions—whichever is greater and the qualified business income deduction if applicable. Your taxable income is what you'll use to determine your tax bracket. Note, with changes from the Tax Cut and Jobs Act, personal and dependent exemptions, which may have lowered your taxable income, were eliminated from 2018 through 2025.

Payroll tax

consists of Social Security and Medicare taxes, otherwise known as Federal Insurance Contributions Act (FICA) tax. FICA tax is an employer-employee tax, meaning both you and your employees contribute to it. Payroll tax is a percentage of an employee's pay.