How to calculate your taxes

Ever wondered how to calculate your taxes? This article is a basic introduction to how the US tax system works for income tax (this is the tax applied to earned income, such as wages, and some other types of income such as bank account interested).

To work out your tax, you follow this basic process:

1. Add up all your income
2. Subtract your standard deduction (or you can add up your actual deductions and subtract that instead)
3. Subtract your exemption, which is an amount for each of your dependents (spouse, children)
4. Calculate your tax

The value your calulcate at step 3 is your total taxable income. You now use the IRS tax tables to calculate your tax. The tax tables split your income into bands (called "brackets"). Think of the bands like buckets - you start by "pouring" your income into the 10% bucket. That buckets gets full after you've poured in $7,825, so now start the pour income into the 15% bucket. When that bucket gets full, start pouring income into the 25% bucket, and so on.

Let's say your total taxable income was $7,000. You pour this income into the 10% bucket which can hold $7,825, so all your income fits into this bucket. Calculate the your tax based on the amount in the bucket:

• 10% of $7,000 (that is, $700)

Now let's say your total taxable income was $10,000. This time, you fill up the 10% bucket with $7,825 of income. The remainder goes into the 15% bucket. The amount in this bucket $10,000 minus $7,825, or $2,175. Your tax is the total tax owed for both buckets:

• 10% of $7,825 plus
• 15% of $2,175

Which comes to about $1108.

Your marginal rate is this highest rate bucket into which you poured your income. In the second example, you poured income into the 10% and 15% buckets, so your marginal rate is 15%.

Some people think this means they paid 15% of their income in tax. That isn't true. You still paid 10% on the first $7,825, and paid 0% (no tax at all) on your standard deduction and exemptions. The marginal tax rate is the tax rate you will pay on the next dollar of income. Let's say your boss gave you a raise of $1 (a pretty stingy boss). This raises your total taxable income to $10,001. Since your marginal rate is 15%, you would pay 15% of the $1 in tax. Of course, if your raise took you into the next tax bracket, then you would owe tax at 25% on the amount over $31,850.

While we are here, let's clear up one myth about marginal rates. Some people think that if they get a raise that takes them into the next marginal tax rate, then you'll get less take home pay. That is not true. Remember that tax rates are like buckets -- you'll only pay the higher rate on the amount of the raise that takes you into the next bucket. You will owe more tax. But your take home pay will never decrease solely due to a raise (I guess that there may be highly complex situations where this does occur).

But let's go back to a taxable income $10,000. To get a taxable income of $10,000, that means your gross income would be $18,750 (remember you get to subtract your deductions and exemptions from your gross income to get to your taxable income). So if you had a gross income of $18,750 your tax is $1,108.

What percentage of your gross income did you actually pay in taxes? Simply divide the tax by your gross income ($1,108 divided by $18,750). This gives an effective tax rate of 5.9%. So while your marginal tax rate is 15%, you only paid 5.9% of your gross income in tax!

This is a simplified view of how taxes are calculated, so don't rely on this to calculate your actual tax. For that, use a tax preparation program, use the forms on irs.gov, or see a tax preparer. However if you know your gross income you can use this method to work out your marginal tax rate and your effective tax rate.