Taxes - a quick overview of the basics

Spring is coming.

Mar 08, 2025

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Very few people want to think about taxes. Tedium, confusion, following a lot of rules you wish you didn’t have to learn — I get it. But tax awareness is important. One reason, of course, is that you’re obligated to file an accurate personal tax return. But you could hire someone and mostly forget about it.

A few other reasons are harder to ignore. Informed planning can increase your wealth by reducing the tax you pay. Diversification is often called the only free lunch in investing, but using tax awareness to increase your after-tax return is something close to a free lunch. You don’t have to compete with anyone else for the increase in gains provided by minimizing tax. And taxes aren’t a self-contained subject you can keep in a corner. They intrude into so many financial topics, like deciding whether to invest more money or pay down debt faster.

You can also minimize hassle. There are mistakes and suboptimal actions that your tax preparer can’t fix retroactively. Mistakes can lead to needless stress, paperwork, and potential tax penalties (or money otherwise lost). But taxes don’t need to be intimidating! They can be straightforward if you equip yourself with basic knowledge and plan ahead.

If nothing else motivates you to learn, consider that tax laws are a window into your own society. Who takes and who gives? How does this change over an individual’s life? Does the tax code need to be this complicated? What are the benefits and drawbacks of different types of taxes? How should we vote to change our taxes? These are questions you can begin to consider only if you choose to inform yourself.

All you have to do is keep reading.

Returns and refunds

The difference between a “tax return” and a “tax refund” is commonly misunderstood. Your tax return is the documentation you send to the IRS (and state-level counterparts) each year. Often you’ll be owed money and receive a payment from the IRS. This is not your return; it is your refund.

Receiving a large refund may be psychologically rewarding, but it is not a benefit. It means that you overpaid taxes and the IRS is refunding the overpayment. The refund you receive, or the payment you make, when you file your return is meant to resolve the difference between the amount you already paid and your tax liability. If your refund (or the amount you owe) is small, that means tax was accurately withheld from your paychecks (or otherwise sent to the IRS throughout the year).

In the top part of this visual, tax withheld is less than tax liability, so tax is owed. In the bottom part, tax withheld is greater than tax liability, so tax is refunded.

Filing status

Your filing status is an essential part of your tax return, and it’s partly determined by your marital status on the last day of the year. Most people who are not married are single filers, and most who are married are joint filers. Married people can also file separately, but it generally leads to paying more tax, so the default for married people should be to file jointly. Married filing separately is not the same as the single filing status. Married people cannot choose to be single filers, even if it lowers their tax burden.

You can claim a dependent on your tax return if you provided more than half of someone’s financial and housing support in that year, among other conditions. As you’d expect, the most common dependents are children, but others can be dependents as well. Taxpayers with children can qualify for tax breaks like the child tax credit. If an unmarried person has a qualifying dependent, they can lower their tax bill by filing with the “head of household” status (instead of the single status).

Tax year

If I say something about “my 2023 taxes”, am I referring to taxes I paid on income earned in 2023, or the tax return I filed in 2023 based on income earned in 2022? The term “tax year” can help avoid ambiguity. Most Americans filed their tax returns for the 2023 tax year in early 2024. If you were legally married on the last day of 2024, you’ll probably file jointly with your spouse for the 2024 tax year in early 2025. The last day of the tax year also determines your age for tax purposes.

Standard deduction vs. itemized deductions

When calculating federal income tax, everyone gets to subtract some amount from their taxable income. Most American households take the standard deduction, so they subtract $15,750 (as single filers) or $31,500 (as joint filers) from their taxable income. These numbers apply to the 2025 tax year. Like many tax figures, they’re indexed to inflation, so they tend to increase each year. People over 65 have a slightly augmented standard deduction.1

Some people can subtract more than the standard deduction by itemizing their deductions. If all of their itemized deductions add up to more than the standard deduction, then it probably makes sense to itemize. These deductions can include state and local tax, mortgage interest, medical expenses, and charitable donations.

The standard deduction is simple and effortless, but itemizing has a lot of rules. Only some mortgage interest and some medical expenses are eligible, for example. Since 2018, the standard deduction has been a no-brainer for the bulk of American households.

Those who take the standard deduction aren’t barred from all other deductions. “Above-the-line” deductions are still available, like the one for deductible retirement account contributions.

All of the above applies to federal taxes, but many states have a similar system. Some don’t: Pennsylvania, for instance, has a flat income tax rate with no standard deduction. Several states, including Texas and Florida, have no income tax.

Marginal vs. effective tax rates

You take your first bite of a personal pizza — it’s delicious! You keep eating and it’s great for a while, but as you take the last few bites, you’re feeling very full and enjoying it much less. Your average enjoyment of the pizza was high. But your marginal enjoyment of the last bites of pizza were low. If you made yourself keep eating, your marginal enjoyment would keep declining.

An average or effective tax rate is the rate at which you pay tax when all dollars are considered. A marginal tax rate is the rate at which you pay tax on the next dollar you earn. We can imagine a simple tax system like the following:

The first $10,000 of income is taxed at 10%
Income between $10,000 and $30,000 is taxed at 20%
Income above $30,000 is taxed at 30%

Each of these is a bracket: a range of taxable income that is taxed at a certain rate. Let’s say we have a taxable income of $40,000. We would fill up the first and second brackets, paying 10% × $10,000 = $1,000 in the first bracket and 20% × $20,000 = $4,000 in the second, larger bracket. We would also pay 30% × $10,000 = $3,000 in the top tax bracket. 30% is the rate we would pay on any additional dollars earned, so our marginal rate is 30%. In total, we owe $8,000 on $40,000 of taxable income, so our effective rate is $8,000 / $40,000 = 20%.

If we asked:

How much of my $40,000 income do I lose to tax?

The answer would be our effective tax rate, 20% or $8,000. But if we asked:

How much of a $20,000 raise would I lose to tax?

The answer would be based on our marginal tax rate: 30% of $20,000 is $6,000.

A $20,000 raise would increase our effective tax rate, because a larger portion of our income would be taxed at the highest rate. We would pay $14,000 of tax on $60,000 of income, giving us an effective rate of 23.3% instead of 20%.

If you aren’t sure you understand marginal tax rates, and how a marginal rate differs from an effective rate, go ahead and watch this brief video. This is a prerequisite to understanding how your own taxes work, and how taxes affect other decisions.

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Income tax vs. payroll tax

The section above gave a toy example of how income tax works. Federal income tax is directed toward the general fund of the US government, which is the source of most federal spending. On the other hand, federal payroll tax goes to trust funds for Social Security and Medicare. An employee and their employer each pays 6.2% of wages to Social Security and 1.45% to Medicare, for a total of 15.3%. You can see only your half (7.65%) withheld from your paystubs, so most people aren’t aware of the employer’s half. Social Security tax is capped at a high income threshold — $176,100 in 2025 — above which the tax ceases. The Medicare tax has no income cap and eventually jumps to 2.35% at higher incomes.

Federal payroll tax starts at the first dollar, and for most people it applies to every dollar at a flat rate. Federal income tax is progressive, which means that those with higher taxable incomes pay higher rates.

Deductions apply to income tax, not payroll tax. You can take the standard deduction or itemize, but it won’t touch payroll tax.

Social Security old age benefits are determined by the amounts you pay to Social Security tax throughout your working life. The more you earn, the more tax you pay, and the more Social Security benefits you can receive. It’s not a linear scale: higher earners get less benefit per dollar contributed than do lower earners. Because wages above the income cap aren’t subject to Social Security tax, they don’t increase your eventual benefits.

He’s three years old and has forgotten to file every year.

Credits and deductions

Credits and deductions can reduce your taxes, but not in the same way. A tax credit is a simple, dollar-for-dollar reduction. If your federal income tax liability for a given year is $8,000, and you receive a $1,000 credit, your tax liability is reduced by $1,000.

On the other hand, a deduction reduces the amount of income that is subject to income tax. If you’re eligible for the student loan interest deduction and you paid $1,000 of interest, you can use the deduction to subtract $1,000 from your taxable income.

If we recall the example above with a 30% marginal rate, we can answer another question:

How much tax would a $1,000 deduction save me?

Without the deduction, that $1,000 would have been taxed at 30%. So it saves us 30% × $1,000 = $300.2

Okay, we understand deductions and credits. Additionally, there are two broad types of credits: refundable and nonrefundable.

A refundable credit is better: it can not only reduce income tax liability to zero, but it can make it negative, resulting in a payment to the tax filer. That’s not the same as a tax refund. If your federal tax liability is $6,000 in a given year, and you withheld $7,000, you’ll receive a $1,000 refund. But you still paid the IRS $6,000 overall. That’s very far from a negative tax liability, which is generally due to low income. The earned income credit is a common refundable credit.

A nonrefundable credit can lower your income tax liability to zero, but cannot reduce it further. People who have low incomes and are eligible for a nonrefundable credit may find that the credit is worth less than they thought, because they owed very little federal income tax in the first place. And even if they can erase income tax liability, their payroll tax burden doesn’t change.

Filing your tax return

Most people will have all the info they need to file their return for the 2025 tax year by mid-February 2026. Each year’s return is due by April 15 (or, if April 15 is not a business day, the first business day after April 15). Requesting an extension is a common practice, especially for tax professionals who are doing many returns. If you file electronically, the IRS might quickly accept your return — possibly in less than an hour. State tax departments tend to process more slowly than the IRS. If you file a paper return, expect a long (and unknowable) response time.

Personally I use FreeTaxUSA to file my tax return, and it’s great for the typical taxpayer who wants to do it on their own. They’re part of the IRS Free File Alliance, so you can file for free if you meet the income requirements. If you don’t qualify for a free return, they charge an extremely reasonable $0 for the federal return and $15 per state return.

If DIY doesn’t sound good to you, then you can hire a tax pro like an enrolled agent (EA) or a certified public accountant (CPA). Many states don’t require licensure for tax preparers, and there’s no federal requirement, but I would still suggest working with an EA or CPA.

If your tax situation is not simple, I definitely recommend hiring a professional. This could be if you’re a business owner, a dual citizen, or recently divorced. Or if you’ve made your situation complex by failing to file in past years or filing incorrectly, rectify that as soon as possible with professional help.

Later this tax season, we’ll show how a typical American, with a job and some investments, could do their own tax return. See you next week!

That post is now available:

Doing your own tax return is easy

Robert

Apr 15

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Further resources

Every Money IRL post is organized in The Omni-Post, and all vocab terms are here.

Mr. Beat (not Mr. Beast) has a good video explaining every type of tax.

Check out this video on marginal vs. effective tax rates.

Nerdwallet has great explanations and reference posts on taxes, like this one with all the federal income tax rates. The IRS website itself is pretty good!

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