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Understanding taxes

Payroll Taxes and Federal Income Tax Withholding Jump to the top of the page

Employers withhold taxes from employees' pay.

  • Gross pay is the amount the employee earns.
  • Net pay, or take-home pay, is the amount the employee receives after deductions.

The difference between gross pay and net pay is:

  • Social Security taxes
  • Medicare taxes
  • Income tax withheld
  • Other amounts withheld

Employers send the withheld taxes to the taxing authorities.

Employees complete Form W-4, Employee's Withholding Allowance Certificate to determine how much federal income tax to withhold.

The amount of federal income tax withholding depends on

  • the employee's marital status,
  • the number of withholding allowances claimed by the employee,
  • any additional amount the employee wants to withhold, and
  • any exemptions from withholding that the employee claims.

Wage and Tip Income Jump to the top of the page

Wages and Salaries

Wages, salaries, bonuses, and commissions are compensation received by employees for services performed.

Tip Income

Tips are received as gratuities by food servers, baggage handlers, hairdressers, and others for services performed. Tips go beyond the stated amount of the bill and are given voluntarily. Employee compensation and tips may be in the form of cash, goods and services, awards, and taxable benefits.

Interest Income Jump to the top of the page

Interest is the charge for the use of borrowed money. In most cases you will earn interest if you let others use your money. Your money earns interest when it is:

  • deposited in accounts in banks, savings and loans, and credit unions.
  • used to buy certificates of deposit or bonds.
  • lent to another person or business.

Interest is considered unearned income because money, not a person, is working to earn the income.

Taxable Interest Income is earned from

  • savings and checking accounts.
  • U.S. Savings Bonds.
  • savings certificates (certificates of deposit or CDs).
  • money market certificates.

Tax-exempt Interest Income is earned from bonds issued by entities in states, cities, counties, or the District of Columbia, such as:

  • port authorities.
  • toll-road commissions.
  • community redevelopment agencies.
  • qualified volunteer fire departments.

Dependents Jump to the top of the page

A dependent may be either a “Qualifying Child” or a “Qualifying Relative.”

A qualifying child must have the following requirements:

  • To be your qualifying child, the child must be younger than you.
  • A child cannot be your qualifying child if he or she files a joint return, unless the return was filed only as a claim for refund.
  • If the parents of a child can claim the child as a qualifying child but no parent claims the child, no one else can claim the child as a qualifying child unless that person’s AGI is higher than the highest AGI of any parent of the child.
  • Your child is a qualifying child for purposes of the child tax credit only if you can and do claim an exemption for him or her.

A. To claim a dependency exemption for a qualifying child, all of the qualifying child dependency tests must be met:

  • Dependent Taxpayer Test
  • Joint Return Test
  • Citizenship Test
  • Relationship Test
  • Age Test
  • Residency Test
  • Support Test

B. To claim a dependency exemption for a qualifying relative, the person must meet the following tests:

  • Dependent Taxpayer Test
  • Joint Return Test
  • Citizenship Test
  • Not a Qualifying Child Test
  • Member of Household or Relationship Test
  • Gross Income Test
  • Support Test

Filing Status Jump to the top of the page

The filing status determines the rate at which income is taxed.

The five filing statuses are:

  • single
  • married filing a joint return
  • married filing a separate return
  • head of household
  • qualifying widow(er) with dependent child

Some taxpayers can qualify for more than one filing status. Usually, taxpayers choose the filing status that results in the lowest tax.

Exemptions Jump to the top of the page

There are two types of exemptions:

  • personal exemptions
  • dependency exemptions

Each exemption reduces the income that is subject to tax by the exemption amount. The exemption amount changes every year.

  • For 2008, the exemption amount was $3,500.
  • In 2009, the exemption amount is $3,650.

A taxpayer cannot claim an exemption for a person who can be claimed as a dependent on another tax return.

Standard Deduction Jump to the top of the page

The standard deduction reduces the income that is subject to tax. The amount of the standard deduction depends on

  • the filing status,
  • the age of the taxpayer and spouse,
  • whether the taxpayer or spouse is blind, and
  • whether the taxpayer can be claimed as a dependent on another taxpayer's return.

Claiming Child Tax Credit and Additional Child Tax Credit Jump to the top of the page

The child tax credit allows taxpayers to claim a tax credit of up to $1,000 per qualifying child.

To claim the child tax credit, there are:

  • requirements for the qualifying child
  • requirements for the taxpayer
  • limits on the amount of credit

In order to claim the child tax credit, the taxpayer must have at least one eligible child.

Tax Credit for Child and Dependent Care Expenses Jump to the top of the page

A tax credit is a dollar-for-dollar reduction of the tax.

The tax credit for child and dependent care expenses allows taxpayers to claim a credit for expenses paid for the care of

  • children under age 13
  • a disabled spouse or dependent

To claim the credit, there are requirements for the:

  • taxpayer
  • child or dependent
  • expenses

There is a limit to the amount of qualifying expenses. The credit is a percentage of the qualifying expenses.

Education Credits Jump to the top of the page

There are two tax credits taxpayers may claim for themselves or their dependents, for higher education:

  • American Opportunity Credit (previously known as the Hope Credit)
  • Lifetime Learning Credit

Form 8863, Education Credits, is used to determine eligibility and figure each credit.

Students receive Form 1098-T, Tuition Statement, from eligible educational institutions, which identify tuition and any related expenses paid to the educational institution, and/or reimbursements or refunds.

Taxpayers can choose the credit that will give them the lower tax; but they cannot claim both credits for the same expenses.

Taxpayers who are eligible to claim the American Opportunity Credit and the Lifetime Learning Credit for the same student in the same year, can choose to claim either credit, but not both.

Earned Income CreditJump to the top of the page

The earned income credit is a tax credit for certain people who work and whose earned income and adjusted gross income are under a specified limit.

For 2009, the earned income and adjusted gross income must be less than:

  • $43,279 ($48,279 if married filing jointly) and three or more qualifying children
  • $40,295 ($45,295 if married filing jointly) and two qualifying children
  • $35,463 ($40,463 if married filing jointly) if one qualifying child
  • $13,440 ($18,440 if married filing jointly) and you do not have a qualifying child

There are many rules that apply to the earned income credit.

At the same adjusted gross income level, taxpayers

  • filing a joint return with three or more qualifying children receive the highest earned income credit.
  • filing a joint return with no qualifying children receive the lowest earned income credit.

Eligible taxpayers can receive the earned income credit even if their tax is zero.

Refund, Amount Due, and Record KeepingJump to the top of the page

Taxpayers receive refunds when their total tax payments are greater than the total tax.

  • Refunds can be received by check in the mail or by direct deposit.

Taxpayers must pay an amount due when the total tax is greater than their total tax payments.

  • Payments can be made by check, money order, credit card, or direct debit (electronic filers only).

It is important for taxpayers to keep good records in order to prepare their tax returns and support items on their tax returns.

Electronic Tax Return Preparation and TransmissionJump to the top of the page

Preparation means the completion of all the forms and schedules needed to compute and report the tax.

Returns can be prepared manually or electronically.

Tax transmission means sending the tax return to the taxing authority.

Returns can be transmitted by mail or electronically.

Electronic options include

There are numerous benefits to the electronic preparation and transmission of tax returns.

Self-Employment Income and the Self-Employment TaxJump to the top of the page

A business is a continuous, regular activity that has income or profit as its primary purpose. Independent contractors are self-employed. Self-employed workers control the methods and means of performing services for others. In contrast, employers direct or control the work of their employees. Self-employment profit is self-employment income minus self-employment expenses when self-employment income is greater than self-employment expenses. Self-employment profit increases the income that is subject to tax. Self-employment loss is self-employment income minus self-employment expenses when self-employment income is less than self-employment expenses. Self-employment tax is similar to Social Security and Medicare taxes. The self-employment tax rate in 2009 is 15.3 percent of self-employment profit. The self-employment tax increases the total tax. One-half of the self-employment tax reduces the income that is subject to tax.

Source: http://www.irs.gov/app/understandingTaxes/student/hows.jsp