Understanding Tax Brackets and Income Taxes

Have you ever been curious how your payroll department knows the right amount for income taxes to be withheld from each paycheck?  Or wondered how it is possible that you owe taxes one year yet then receive a huge refund the next year?  It all comes down to your income and the respective tax bracket.      

Every year tax brackets are set for the current year by the IRS.  Each tax bracket designates the tax rate for the respective income level range.  The following table provides the income range in dollars and tax rate percentage for 2007.  

Upon first glance, the structure of the federal tax structure might appear simple.  The majority of people erroneously estimate their expected tax liability by multiplying their gross annual income by the respective tax rate.  However, this simplified calculation generally yields an increased amount in taxes than what is officially owed in taxes.  

Income is federally taxed using a graduated schedule.  Bottom line, what this really means is that your first dollar earned is taxed by a lower tax rate as compared with the last few dollars you earn, if you make over $7,825.  For example, if you filed single with an income of $25,000, then the first part of your income up to $7,825 is taxed at a 10% tax rate.  So you would owe $782 on this part of your income.  After that, every dollar you earn from $7,825 to $25,000 is taxed using the 15% tax rate, meaning you would owe $2576 on this part of your income. Therefore, in total, you will end up owing $3,358 in federal income taxes for the 2007 year.        

Even though the tax rate increases as the total amount that you have earned increases, the amount in federal taxes that is withheld from each paycheck should not change.  The reason is that your payroll department estimates in advance how much you will owe in taxes for the year, where they assume that you have not outside employment. Then they divide that estimated amount evenly across the number of paychecks that you will receive for the year, assuming that you are employed by only them for the entire year.  

So then, it is natural to wonder how exactly they know the right amount to withhold.  Generally, you provide this information by filling out a W-4 form when you start working somewhere.  On the W-4 is where you designate your appropriate filing status, such as single or married and your total number of claimed exemptions.  

Once you officially file your tax return, if too much tax was withheld, then you will get a refund.  Or, if there was too little withheld, then you will owe taxes.  This is the reason why it is necessary to enter the right number of claimed exemptions on the W-4.