Miner & Lemon Blog

Tax Saving Series Part 2 - "Explanation of the Income Tax System or a Day Trip Through Dante's Inferno"

A Short Explanation of the Income Tax System or A Day Trip Through Dante’s Inferno

                According to Will Rogers the income tax system is excruciatingly simple: “If you make any money, the government shoves you in the creek once a year with it in your pockets, and all that don’t get wet you can keep.”  However, there are steps that can be taken to minimize the amount of money that gets “wet.”  I will elaborate on these steps in subsequent posts, but before I do that, I think a short description of how the income tax system works would be appropriate.
                First, Gross Income must be determined by computing “all income from whatever source derived,” less certain postponed and excluded items, such as gifts received, amounts contributed to 401(k) accounts, and proceeds from life insurance.  Second, above the line deductions must be taken to determine the Adjusted Gross Income.  Above the line deductions include (among other items): trade and business expenses of self-employed individuals, contributions to Individual Retirement Accounts, and contributions made by self-employed individuals to pension, profit-sharing, and annuity plans.  And third, below the line deductions, which will be either itemized deductions or the standard deduction, must be taken along with personal and dependent exemptions to finally arrive at Taxable Income.
                Also, it is important to bear in mind the difference between items excluded from gross income and above the line deductions on the one hand and below the line deductions on the other.  This distinction is critical for the reason that all items in the former will reduce Taxable Income, but the same cannot always be said of the latter.  This is because below the line deductions require the taxpayer to make a choice between two mutually exclusive alternatives: either receive the standard deduction or take itemized deductions.  In other words, a taxpayer will always be able to reduce his or her Taxable Income by amounts contributed to 401(k) accounts and Individual Retirement Accounts, but if he or she receives the standard deduction then itemized deductions must be foregone, or, alternatively, if he or she takes itemized deductions then the standard deduction will be unavailable.
                After Taxable Income has been calculated, then the taxpayer’s obligation is determined based upon calculations performed in accordance with the marginal rates.  However, even after this initial calculation of the tax amount, a taxpayer may still be able to lower his or her ultimate tax liability by subtracting credits.  Credits reduce tax on a dollar-for-dollar basis because they are applied directly against the tax due, as opposed to deductions and exemptions which are applied against the taxpayer’s income.  There are two main types of credits: non-refundable and refundable.  Non-refundable credits can reduce a taxpayer’s obligation to zero, but cannot reduce it below zero.  Refundable credits, on the other hand, can reduce a taxpayer’s obligation below zero, and, as a result, can cause a taxpayer to receive a refund.  Several of the more commonly used credits include the non-refundable credit for the elderly and the permanently and totally disabled, the partially refundable child tax credit, and the refundable credit for tax withheld on wages.
                And, in addition to the Federal income tax, Indiana imposes a State income tax of 3.4%, which is determined by reference to the taxpayer’s Federal adjusted gross income along with a few quirks.  Also, there is a county income tax due, the percentage of which varies depending upon the county of residence from .01% to 2.08%.

                Please join me next time for: How to Minimize Income Tax or I Wear a Barrel Because Uncle Sam Took My Slacks.