Category Archives: Taxes

Why Do We Pay Taxes

Why Do We Pay Taxes?

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When April 15th comes you have to file a tax return and pay taxes.  But why do we pay taxes?  Is it because you’re “supposed to,” or because most everyone else does?  Is it because of tradition, or social convention?  Do you pay taxes out of patriotic duty, or even as a practical matter, knowing the government has to have money to function?  Or do you file a tax return because of the IRS, for fear of the consequences of what they might do if you don’t?  While some, none, or all of these reasons may come into play for you, what I want to focus on is helping you to understand the legal basis upon which the government of the United States (through the IRS) compels Americans to file Federal income tax returns and pay taxes.

How the Internal Revenue Code became the law of the land

Prior to 1776, the King of England was the supreme sovereign authority over the 13 Colonies.  This included authority in matters of taxation.  So if the king said there was a tax on tea (or whatever), there was a tax on tea.

In 1776 representatives of the 13 Colonies signed the Declaration of Independence, setting forth the rational, legal, and moral basis for America to sever the ties of British authority, including the right of the British to tax the American colonies.  The 13 Colonies fought and won the Revolutionary War in order to preserve that newfound freedom and independence.

Recognizing the need for a governing body “to promote the general Welfare,” in 1789 the 13 Colonies ratified the United States Constitution “in Order to form a more perfect Union.”  At that time, the Constitution became the supreme law of the land.[1]

As prescribed by the Constitution, Congress became the lawmaking branch of the United States government.  In accordance with this authority, Congress has the power to pass legislation which, when signed by the President (and not overturned by the Supreme Court), becomes the law of the land.

Over time the laws of the United States have been organized into what is known as the U.S. Code.  The U.S. Code is further organized into Titles covering specific areas of law.

In 1913 the 16th Amendment of the United States Constitution was ratified.  It states, “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived… (italics added).”

In accordance with the authority granted to it by the Constitution, Congress created Title 26 of the U.S. Code, which is also known as the Internal Revenue Code.  The Internal Revenue Code contains the tax laws of the United States.

The Internal Revenue Code requires U.S. citizens and residents to pay taxes

Now that it’s been established that the Internal Revenue Code (or “IRC”) is the law of the land, where does it say in the Code that people have to file income tax returns and pay taxes?

Congress didn’t beat around the bush answering that question.  At the very beginning of the Code, IRC Section 1 states, “There is hereby imposed on the taxable income of [single and married persons]…a taxdetermined in accordance with the following table[s] (italics added).”  Tables are then laid out in the Internal Revenue Code showing the tax you owe on your taxable income based on your filing status (single, married filing joint, head of household, etc.).

If your tax is based on “taxable income,” how is that defined according to the Code?  IRC 63 states, “…the term ‘taxable income’ means gross income minus [allowable deductions].”

And what’s “gross income?”  You’re going to love this.  According to IRC 61, “…gross income means allincome from whatever source derived…”  And what exactly does that mean?  It means that unless the Internal Revenue Code itself provides an exception, the income of all people everywhere is subject to taxation in the United States, and all people, whether married or single, foreign or domestic, on Earth or living in outer space, owe tax on their “taxable income.”

Wow!  Asserting tax jurisdiction over everyone everywhere…that’s bold!  But how can that be?  Did the United States Congress really throw down the gauntlet and declare tax warfare on the rest of the world and you just missed it?  Not quite.  Without getting into mind-numbing detail, I’ll just say that according to IRC 871 it turns out that nonresident aliens are only taxable in the U.S. to the extent that they have meaningful business, employment, or investment connections to the United States.  While that’s good news for foreigners, the flip side is that all of following categories of people are required to pay taxes on their “taxable income.[2]”

  • United States citizens who live anywhere in the world (or anywhere in the known universe for that matter).
  • Green card holders (otherwise known as “lawful permanent residents”) who live anywhere in the world.[3]
  • Non-U.S. citizens who are “effectively connected” to the United States for tax purposes.

The Internal Revenue Code requires you to file tax returns

Okay, you’ve now come to the realization that you legally have to pay taxes.  So how much do you owe?  And how do you determine how much tax you owe?  You do that by filling out the applicable tax return, which for most individuals is Form 1040, “U.S. Individual Income Tax Return.” [4]

As intimidating and confusing as a 1040 can be, it’s actually far better than the alternative, which would be to read through the Internal Revenue Code and manually determine what you owe in taxes with pen and paper or a spreadsheet.  Said another way, Form 1040 is designed to provide you with an organized framework to calculate your income tax obligations in accordance with the laws of the Internal Revenue Code.

But let’s just say for argument’s sake that you don’t feel like filling out a 1040, or any other IRS-published income tax form.  Can you just calculate your tax by hand, send a check to the U.S. Treasury and be done with it?  The answer is no.  IRC Section 6011 states, “…any person made liable for any [income taxes]…shall make a return or statement according to the forms and regulations prescribed by the Secretary [of the Treasury] (italics added).”  And what are the prescribed forms?  It’s those developed and published by the Internal Revenue Service, the division of the U.S. Treasury charged with administering and enforcing the revenue laws of the United States.

There are no exceptions to paying taxes if you have enough income

After reading all of this you might say, “But wait, you probably didn’t realize there’s an exception to paying Federal taxes for me because I’m…”  You’re what?  A senior?  A child or a student?  A descendent of an enslaved, oppressed, or persecuted people?  A member of a certain religion?  That you’re opposed to the current President or other elected officials?  That you’re against some aspect of U.S. foreign policy?  Or perhaps you’ve been led to believe that you’re exempt from Federal income taxes based on some kind of intellectual, pseudo-legal, wacko argument that you found on the Internet?  Despite all of the myths, misinformation, and clever scams out there, none of these are exceptions to filing income tax returns and paying taxes.  In short, all Americans whose income exceeds a certain threshold are subject income taxes…period.

Follow the law…or face the consequences

Here’s what it all boils down to.

  • The United States Constitution is the supreme law of the land.
  • The Constitution grants Congress the power to tax income.
  • The Internal Revenue Code contains the tax laws of the United States.
  • According to the law, United States citizens, green card holders, and certain foreigners have to pay taxes on their taxable income.
  • Taxes have to be calculated on official government (IRS) forms.

That said, the government realizes that regular people often have a hard time understanding and applying the tax laws, and they will generally work with you if you’re making an honest effort to meet your income tax obligations.  But if you try to avoid paying taxes through the use flimsy or impassioned arguments that have no basis in the law, you’re going suffer some serious pain when the IRS brings your fantasy world comes crashing down on you because, like it or not, agree with it or not, or want it or not, the Internal Revenue Code is the law of the land.

[1] Quotes are from the preamble to the United States Constitution.  The Constitution can be referenced at http://www.ushistory.org/documents/constitution.htm

[2] A “nonresident alien” is essentially a foreigner who does not reside in the United States.  For a more formal definition see IRC 7701(b) and related references.

[3] Why would green card holders be subject to U.S. tax if they don’t even live in the States?  It’s because they have the right to live and work in the U.S. anytime they want, and for that privilege the United States requires that they pay taxes.

[4] If you meet the qualifications, you can instead file a Form 1040A or a 1040EZ.  In theory your tax will come out just the same as if you had filed a full-blown 1040, but these forms are designed to be shorter and easier to complete.

Health Insurance Premiums Affect Your Paycheck

How Health Insurance Premiums Affect Your Paycheck and Save Taxes

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If you have elected family health coverage through your employer and your premiums are $350 a month then it would be easy to think that the net effect on your paycheck would be $350 a month.[1]  However, there is more to it than that, and to fully understand your paycheck you need to know the positive effects that your heath insurance premium payments have on your payroll-related calculations.

Health insurance premium contributions reduce your FICA (or payroll) taxes

If your employer deducts your health insurance premiums directly from your paycheck (as opposed to you writing a check to pay for health insurance) then it saves you taxes by lowering your FICA wage base.  Note that Social Security and Medicare taxes combined together are known as “FICA” or “payroll” taxes.  A comprehensive example of how to calculate your taxable FICA wages, as well as how health insurance premiums fit into that.  However, just focusing on health insurance for now, here is an illustration of how your employee-sponsored health insurance premiums reduce your FICA taxes.[2]

What this example shows is, all things being equal, if your health insurance premiums are deducted from your paycheck then it will lower your taxable FICA wages by $350, and will result in a FICA tax savings of $19.77 a month (or $237.24 a year).

Health insurance premium contributions save you even more on income taxes

Following the principles above relating to FICA taxes, employer-sponsored health insurance contributions also result in substantial savings on your Federal and state income taxes, which is illustrated as follows.[3]

Based on these figures, being able to purchase health insurance through your employer would lower your income tax base by $350, and that would save you $73.50 a month (or $882.00 a year) in income taxes.

Summary

Having health insurance premiums deducted from your paycheck saves you a substantial amount in taxes.  Why?  Because it because it reduces your taxable wage base before FICA, Federal and state income taxes are applied. Based on the figures in the examples above, your combined FICA and income tax savings would be $93.28 a month ($19.78 plus $73.50) or $1,119.36 a year ($93.28 x 12 months).[4]  That’s a substantial amount of money for a regular person!  As a result, in evaluating your overall financial situation it’s very important to not only consider the availability of health insurance through your employer, but to take into account the tax-related benefits of health insurance contributions as well.


[1] The average annual cost of family health insurance premiums in 2010 was $13,770.  Of that, employees had to cover approximately 27%, or $3,718.  That averages out to be about $310 a month, which I have rounded up to $350 due to the higher cost of health insurance in many parts of the country.  For reference, see http://ehbs.kff.org/?page=charts&id=1&sn=6&p=1 and http://www.consumerhealthratings.com/index.php?action=showSubCats&cat_id=179.

[2] The FICA tax rate of 5.65% is based on the 2011 Social Security tax rate of 4.2% plus the Medicare tax rate of 1.45%.  As of this writing the 4.2% Social Security tax rate is slated to expire at the end of 2011 when it will go back to 6.2%, but it’s not yet clear whether the law will be extended, modified, or allowed to expire.

[3] The 21% tax rate assumes a 15% Federal tax rate and a 6% state tax rate.

[4] Looking at this another way, the net cost of your health insurance wasn’t $350, but $256.73 (the $350 premium less tax savings of $93.28).

How Social Security Tax & Medicare Tax (or FICA) Work

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“I want to find out who this FICA guy is and how come he’s taking so much of my money.” – Nick Kypreos (former professional hockey player).

Payroll taxes are based on your taxable (rather than gross) wages

The combined total of your Social Security and Medicare taxes are often referred to as “payroll taxes, ” “FICA,” or “FICA taxes.”[1]  The Medicare tax rate on wages is 1.45%.  Since 1990 the Social Security portion of FICA has been 6.2% of wages, but for 2011 only the rate was cut to 4.2% as a means to stimulate the economy.  Given this is the case, if your salary was $50,000 a year then it would be natural to assume that your monthly Social Security and Medicare taxes would be $235.42, which paystub breakdown is calculated as follows (assuming that the temporary 4.2% Social Security rate applies to this and the other examples that follow).[2]

How FICA Tax Works 1

What if I told you instead that your actual payroll taxes were $184.47, or $50.95 less than what you expected ($235.42 less $184.47)?  What accounts for the difference?  Exactly how is the Social Security and Medicare tax breakdown on your paycheck calculated?  To answer that the most important thing you need to understand is that Social Security and Medicare taxes are not driven by gross monthly wages, but by your taxable wages.  This is illustrated by the following example, which shows how the $184.47 of payroll taxes referred to above was calculated.[3]

How Social Security Tax Works 2

Again, a key thing to take away from this example is that by default your gross wages or salary (the $4,166.67) is the starting point for calculating your payroll taxes, but there certain things which can either increase or decrease your taxable FICA wage base.  In the example above you received $15 in non-cash taxable fringe benefits, and that served to increase your FICA taxable base.  On the other hand, your health insurance premiums and “FSA” (or “flexible spending account”) contributions served to decrease your FICA taxable base.  Thus, after taking into account all of the adjustments shown above, your taxable FICA wage base decreased from $4,166.67 (your gross monthly wages) to $3,265.00.

Why calculate Social Security and Medicare taxes separately?

If you compare the Social Security and Medicare tax calculations above you’ll notice the only difference between the two is that the tax rates are different (4.2% vs. 1.45%).  If that’s the case then why calculate the two taxes separately?  Why not just take your taxable FICA wages ($3,265.00) and multiply it by 5.65% (4.2% plus 1.45%) to arrive at your total FICA taxes of $184.47 ($137.13 plus $47.34)?  There answer is that will actually work for most people.  However, there are two reasons you need to be able to calculate your Social Security and Medicare taxes separately.

  1. The two taxes almost always appear on your paystub as separate figures rather than as one combined FICA tax, so it’s important that you know how to check each of them individually.
  2. If your taxable wages happen to be in excess of $106,800 (congratulations!) then it throws the math off, because wages in excess of that amount are exempt from Social Security taxes whereas all wages are subject to Medicare taxes.[4]

Verify that your payroll taxes are calculated correctly on your paystub

Now that you understand the principles behind calculating Social Security and Medicare taxes, pull out your last paystub and verify that your own FICA taxes are being calculated correctly.  If you’re able to successfully do so then feel free to skip to the “Summary” paragraph at the end of this article. If, however, you’re still having trouble verifying that the Social Security and Medicare taxes on your own paystub are being calculated correctly then you first need to determine what your employer is using as your taxable FICA wage base.  You do that by dividing the Medicare taxes on your pay stub ($47.34 in our example) by the Medicare tax rate (1.45%), illustrated as follows.[5]

FICA Tax or Medicare

Do you see what you’ve done?  Using the formula above you’ve mathematically determined that, according to your company’s payroll department, your taxable Medicare wages are $3,264.83.  That’s significant because remember, by default, Medicare taxes are based on your gross wages.  Therefore, if your gross wages ($4,166.67) are not equal to your taxable Medicare wages ($3,264.83) then it means they’ve have been adjusted for payroll tax purposes, and the amount of the adjustment can be calculated as follows.

FICA Tax

So how do you account for this difference of $901.84 between your gross monthly wages and your taxable Medicare wages?  Referring back to earlier illustrations in this article, you will find the following:

Social Security Tax FICA Tax

What this shows is that after you take into account payroll tax (or FICA) deductions related to your health insurance and flexible spending account contributions, you can fully explain the difference between your gross wages and your taxable Medicare wages except for a fairly small difference of $14.83.  Not bad.  But wait, if you think about what you read in the previous article about non-cash fringe benefits then does that give you an idea of what the difference could be?  It’s very close to the $15 of taxable fringe benefits that you received (see above), and when you add those back then your reconciliation is only off by 17 cents.[6]

How FICA Tax Social Security Tax Work

In summary, you can verify that your Medicare tax ($47.34) is correct by verifying that your Medicare tax base ($3,265.00) is correct.  In addition, once you’ve verified your Medicare tax base, you can use the following method to verify that your Social Security taxes are also being calculated correctly.[7]

How FICA Tax Social Security Tax Work

Summary

So what’s the point of this whole exercise?  After all, isn’t your company’s payroll department supposed to ensure that your Social Security and Medicare taxes are being calculated correctly?  Of course they are, but if you’re serious about managing your money then you shouldn’t just blindly fork over $184.47 ($137.13 in Social Security and $47.34 in Medicare taxes) to the government every month unless you know why.  No, if you’re serious about managing your money then you’ll make the effort to independently verify that your payroll taxes are being calculated correctly.  If you’re unable to do so then contact your employer’s payroll department and have them walk you through how they came up with the numbers on your paystub.

[1] FICA stands for “Federal Income and Contributions Act,” which is where the federal government derives its authority to levy payroll taxes.  Source: Internal Revenue Code Section 3101.

[2] For purposes of this example and the ones below it’s assumed you are paid on a monthly basis.  However, the same principles apply if you are paid bi-monthly, weekly, etc.

[3] The figures in this example are drawn from my introductory article on how to read checks.

[4] The $106,800 Social Security wage base is accurate for 2017 (it’s adjusted annually for inflation).  See https://www.ssa.gov/news/press/factsheets/colafacts2020.pdf.  For more information how to handle high wages and other special issues related to Social Security tax calculations click here.

[5] Why is it important to use the Medicare rather than the Social Security tax rate to determine your taxable FICA base?  The reason is that Medicare doesn’t have a taxable wage ceiling, so the formula will work every time.  On other hand, because the Social Security wage base is capped at $106,800 (2011) then the formula won’t work if your wages happen to be in excess of that amount.  If you find this confusing then just remember that it boils down to this: use the Medicare tax rate of 1.45% in the formula!

[6] You don’t need to contact your payroll over an amount as small as 17 cents; it’s just a rounding difference.

[7] Note that if your taxable FICA wages are in excess of $106,800 (based on 2017 figures) then your Social Security taxes for the year should be capped at $4,485.60 ($106,800 times 4.2%).

How to read checks pay stub meaning

How To Read Checks – Pay Stub Explained

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Understand Pay Stub Meaning & How To Read Checks

Some of your most expensive bills are in your paycheck

In order to manage your money effectively you need to have a clear understanding of all of your expenses.  What many people either forget or don’t realize is that some of their most expensive bills don’t show up in the mail, but in their paycheck!  For example, if your salary is $50,000 a year and you’re paid once a month then your gross monthly wages (or salary) would be calculated as follows.[1]

Pay Stub Meaning & How To Read Checks

What this means is barring any complicating factors, you should expect to receive exactly $4,166.67 each month.  But of course things are not that simple because, as anyone who has ever gotten a paycheck knows, there are complicating factors!  As it relates to our example, what if I told you that instead of your take-home pay (meaning the amount of money that actually made it to your bank account) being $4,166.67, it was only $2,482.11?  What’s going on here?  How can your net pay be $1,684.56 less than what you earned, an amount that’s over 40% of your total paycheck?  In short, what financial sharks devoured massive chunks out of your monthly earnings before they ever even got to your bank account?!?

How To Read Checks – Sample Paycheck Breakdown

Based on the figures above, the following breakdown accounts for the $1,684.56 reduction in gross pay of $4,166.67, to arrive at a net paycheck of $2,482.11.

Gross Wages (or Base Monthly Salary) $4,166.67
   
Less: Health Insurance ($350.00)
Less: FSA – Medical ($166.67)
Less: FSA – Dependent Care ($400.00)
   
Less: Retirement Plan Contribution ($416.67)
   
Less: Social Security ($137.13)
Less: Medicare ($47.34)
Less: Federal Income Tax ($65.83)
Less: State Income Tax ($105.92)
   
Less: Disability Insurance ($30.00)
Less: Company Deductions ($45.00)
Add: Reimbursements $80.00
   
Equals: Net (or Take-Home) Pay $2,482.11

It’s important to note here that not everything that’s taken out of your paycheck is bad.  For example, the $416.67 contribution to your retirement plan will certainly help you in the future, but you also need to take into account that it’s $416.67 less in the current month that you’ll have to pay the bills, cover day-to-day expenses, and do other things you would need or like to.

Know where every penny of your paycheck is going and why

Fully understanding the breakdown of your paycheck is one of the great mysteries of the known universe.  To cut through all the complexity, my approach to paycheck analysis boils down to this: if your employer has agreed to pay you $4,166.67 a month then you should expect them to deposit exactly that much each month into your bank account, and if you get any less ($1,684.56 less in our example!) then you should figure out where every penny went and why.  The purpose of this article is to give you with a starting point to do just that, by providing you with links to relevant paycheck-related information, examples, and insights (see below).

Related articles and information

To continue this series and read the next article on how to read your paycheck.   Also, you can click on any of the links in the sample paycheck breakdown above if you want to go straight to information on a specific area of your paycheck.  Finally, you can also refer to other information on taxes.

**********

[1] According to government statistics, the median income of a household in the United States in 2018 was $61,372 (see https://www.census.gov/newsroom/press-releases/2018/income-poverty.html).  While that figure is a bit dated, rounding it to $60,000 to make my examples easier to follow.

Taxable Wages vs Gross Salary or Wages

The Taxable Wages vs. Wages (or Salary)

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Gross taxable wages is a major component of paycheck calculations

Your gross taxable wages drives much of what is going on as far as your paycheck is concerned.  For example, it’s the starting point for determining your Social Security and Medicare taxes as well as your federal and state tax withholdings.  But determining your gross taxable wages should be easy, right?  After all, if your salary is $50,000 a year and you’re paid once a month then it would be natural to think that your gross monthly taxable wages would be calculated as follows:[1]

However, what if I told you that your gross monthly taxable wages were actually $4,181.67, or $15 higher than $4,166.67?  What’s going on?  Where is the extra $15 coming from? The answer is that $4,166.67 is equal to your gross monthly wages, not your gross monthly taxable wages.[2]

Non-cash fringe benefits

What’s the difference between your gross monthly wages ($4,166.67) and your gross monthly taxablewages ($4,181.67)?  The answer is that sometimes a company will provide you with non-cash fringe benefits that are taxable.  A non-cash fringe benefit (or simply a “fringe benefit”) is something of monetary value that your employer provides to you in addition to the pay you receive.  If a non-cash fringe benefit is taxable the law requires your employer to add an amount to your gross income equal to the value of benefits you receive.

For our example we’ll assume that your employer has a policy of providing each employee with life insurance coverage equal to three times salary, which in your case comes to $150,000 (your $50,000 base salary x 3).  This exceeds the $50,000 tax-free amount allowed under current law by $100,000, and that extra life insurance coverage would cost $15 a month if you bought it on your own.[3]  And from the government’s perspective that’s exactly the point – it’s as if your employer paid you an extra $15 a month which you then used to purchase life insurance.  As a result, the law requires your employer to add an extra $15 to your gross income each month (or $180 a year) so that it will be included in the taxable wages you’ll report on your income tax return.

Note that in some cases non-cash fringe benefits are also non-taxable.[4]  For example, if a company stocks drink machines with free sodas that any employee can get just by pressing a button then that likely qualifies as a non-cash fringe benefit that’s also non-taxable.  In other words, you’re able to get sodas without for paying for them and you don’t have to count the value of the sodas you consume as taxable wages on your income tax return.  In short, non-cash fringe benefits that are also non-taxable are a way for you to have your soda and drink it too.

Understanding income reporting on your paystub and Form W-2

Now that you know the distinction between gross wages and gross taxable wages you’re in a better position to understand your paycheck.  For example, gross wages ($4,166.67 based on the figures above) on your pay stub should be labeled something along the lines of “Salary,” “Regular Salary,” or “Wages.”  Likewise, your gross taxable wages ($4,181.67 based on the figures above) should also appear on your paystub and be labeled something like “Current,” “Current Taxable Wages,” “Taxable,” or “Taxable Wages.”

Using the principles discussed above you should also have a better understanding of your W-2, the tax form that your employer mails to you at the beginning of each year (e.g. January 2011) telling you how much you need to report in wages on your April 15th tax return for the year that just ended (2010).  So in our example would you expect your taxable wages for the year to be $50,000, right?  No!  Remember, that’s just your salary.  Your taxable wages in box 1 of Form W-2 should be $50,180, equal to your $50,000 base salary plus $180 of non-cash taxable fringe benefits relating to your life insurance coverage ($15 a month x 12 months).  Also, the $180 value of your non-cash taxable life insurance fringe benefit should be separately reported on your W-2 at line 12.

Why knowing how to calculate your gross taxable wages is important

So is all of this small potatoes?  After all, is it really the end of the world if you don’t understand why your taxable income is $15 higher per paycheck than your salary?  No, $15 of extra taxable income a month (which would translate into $2-$4 of extra tax) probably shouldn’t rate high on your list of things to lose sleep over.  However, what if you had more significant non-cash taxable fringe benefits such as the use of a company car, your company paid club dues on your behalf, or you got to take a personal trip on the company plane?  In such cases the value of your non-cash taxable benefits could be significant, and if that’s not something you take into account then you could be in for a nasty surprise when you get your tax bill.

But what if you’re like most regular people you don’t get a company car or have the opportunity to jet around the country in the company plane?  What if all you ever have is that $15 or so difference a month between your gross wages and your gross taxable wages?  Would it really be that big a deal not understand where that difference came from?  As I said before, on the surface it wouldn’t seem to matter very much.  However, in my experience the difference in confidence between those who sort of understand their finances and those who really understand their finances makes a big difference in their ability to make confident, sound, and decisive financial decisions.  And as further articles will show, if you don’t understand the difference between your gross wages and your gross taxable wages then you’ll never fully grasp what’s going on with the rest of your paycheck.

[1] The figures in this example are drawn from my introductory article on how to understand your paycheck.

[2] This example assumes you’re paid once a month, but the same principles apply if you are paid bi-monthly, weekly, etc.

[3] Source: Internal Revenue Code Section 79.