Understanding taxes and brackets

Basics of taxes and how much you will owe

Ever wondered how your employer knows how much money to withhold from your paycheck for income taxes? Or how you might receive a large tax refund one year and end up owing the next? This all relates to the amount of income you earn and the tax bracket that you fall in.

Each year, the Internal Revenue Service, or IRS, sets the tax brackets for that year. A tax bracket dictates what levels of income will be taxed at what tax rate. Here are the tax brackets and income for 2007.

Single $0 - $7,825 $7,825 - $31,850 $31,850 - $77,100 $77,100 - $160,850

Married Filing Jointly $0 - $15,650 $15,650 - $63,700 $63,700 - $128,500 $128,500 - $195,850

Tax Rate 10% 15% 25% 28%

Tax brackets for single individuals making over $160,850 and couples making over $195,850 are taxed at a rate of 33% or higher.

The federal income tax structure isn’t as simple as you might first think. Most people are inclined to simply multiply their expected annual gross income by the tax rate they fall into to calculate the expected income tax for that year. However, this calculation will usually yield a higher amount of taxes than is actually owed.

Your income is taxed at a graduated level. This means that the first dollars you earn are taxed at a lower rate than the last dollars you earn. To illustrate, let’s say you are a single tax filer earning $25,000 per year. The first $7,825 you earn will be taxed at the 10% rate. However, what you earn after $7,825 up to $25,000 will be taxed at the 15% rate. You will owe $3,358 in taxes this year.

Although your tax rate will increase as you move from one tax bracket to the next, the amount of federal tax withheld from your paycheck each period will not change. This is because your employer calculates your annual income tax owed and deducts an equal amount each pay period.

How does your employer know how much income tax to withhold? Remember the stack of papers you filled out when you first started your job? One of these documents was the federal W-4 form. On this form you indicate your filing status (single or married) and the number of exemptions you have. This information helps your employer calculate how much income tax you will owe for the year.

If you end up having too much income tax withheld from your paycheck, you will receive a refund when you file income taxes next year. On the other hand, if you have too little income tax withheld, you’ll end up having to pay income taxes. This is why it’s important to fill out your W-4 with the correct number of exemptions.