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TAX SEASON | How Income Taxes Work

TAX SEASON | How Income Taxes Work

February 09, 2023
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How Income Taxes Work

´╗┐What do gears have in common with taxes? A pile of gears will not do you any good; but when you connect them, they start working together. Your tax documents are the same; they are just a pile of paper scattered about on your desk or table or stuffed in a shoe box; they will only be useful when you put those documents in the proper order and into the hands of a professional. Preparing for tax season is not fun for most, but you do have work to do before handing over your well-organized (hopefully) documents to your tax professional. Read on to learn more about how taxes work. 

The Internal Revenue Service estimates taxpayers and businesses spend about 8 billion hours a year complying with tax-filing requirements. To put this into perspective, if a single company did all this work, it would need about four million full-time employees and be one of the largest industries in the U.S.1

As complex as the details of taxes can be, the income tax process is pretty straightforward. However, most Americans would rather not spend time with the process, which explains why more than half hire a tax professional to assist in their annual filing.2

Remember, this material is not intended as tax or legal advice. Please consult a professional with tax or legal experience for specific information regarding your situation.

Getting Started

The tax process starts with income, and generally, most income received is taxable. A taxpayer's gross income includes work, investments, interest, pensions, and other sources, and the income from all these sources is added together to determine the taxpayer's gross income.

What's not considered income? Gifts, inheritances, workers' compensation benefits, welfare benefits, or cash rebates from a dealer or manufacturer.3

From gross income, adjustments are subtracted. These adjustments may include retirement plan contributions, half of self-employment, and other items.

The result is the adjusted gross income.

From adjusted gross income, deductions are subtracted. With deductions, taxpayers have two choices: the standard deduction or itemized deductions. The standard deduction amount varies based on filing status, as shown on this chart:

Chart Source: IRS.gov, 2022

Itemized deductions can include state and local taxes, charitable contributions, the interest on a home mortgage, and certain unreimbursed job expenses, among other things. Keep in mind that there are limits on the amount of state and local taxes that can be deducted.4

Once deductions have been subtracted, the result is taxable income. Taxable income leads to gross tax liability.

But it's not over yet.

Any tax credits are then subtracted from the gross tax liability. Taxpayers may receive credits for a variety of items, including energy-saving improvements.

The result is the taxpayer's net tax.

Understanding how the tax process works is one thing; doing the work is quite another.

Dixon Financial Group cannot give tax advice, but we are here to guide you through the process when it comes to your investments and provide suggestions now to help reduce your tax liability in the future. Please call the DFG Team so we can answer your questions and be another gear working to help you maintain a financially secure future.

David S. Dixon, CFP®


  1. NTU.org, April 18, 2022
  2. IRS.gov, 2022
  3. The tax code allows an individual to gift up to $16,000 per person in 2022 without triggering gift or estate taxes. An individual can give away up to $12,060,000 without owing any federal tax. Couples can leave up to $24,120,000 without owing any federal tax. Also, remember that some states may have their own estate tax regulations. This material is not intended as tax or legal advice. Please consult a professional with tax or legal experience for specific information regarding your individual situation.
  4. The mortgage interest deduction is the first $750,000 of the loan for a home, and the state and local income taxes deduction is capped at $10,000.

The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. This material was developed and produced by FMG Suite to provide information on a topic that may be of interest. FMG Suite is not affiliated with the named broker-dealer, state- or SEC-registered investment advisory firm. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. Copyright FMG Suite.