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Personal Finance Unit 1: Earning income and taxes

Your income depends on education, skills and career choices, and taxes and deductions turn gross pay into take-home pay.

Covers: Careers and human capital, gross and net pay, paychecks and deductions, types of income, federal income tax, tax forms

Study guide

Income is money received, mostly from work. Human capital, the skills and knowledge people gain through education and training, strongly affects earnings: on average, people with more education earn more and face less unemployment. Career choices also involve opportunity costs, like the time and money spent on college or training. Workers may be paid an hourly wage or a salary, and some earn commissions, tips or bonuses. Employee benefits, such as health insurance, paid time off and retirement matching, are part of total compensation. Gig and self-employed workers have more flexibility but must pay their own taxes and buy their own benefits.

Gross pay is what you earn before deductions; net pay (take-home pay) is what's left after them. A pay stub shows deductions: federal income tax, state and local income tax (in many states), and FICA taxes, which fund Social Security (6.2%) and Medicare (1.45%). Voluntary deductions can include health insurance premiums and retirement contributions. When starting a job, workers fill out a Form W-4 to set federal tax withholding and a Form I-9 to verify they can work in the US. At the end of the year, employers send a W-2 showing wages and taxes withheld; independent contractors receive a 1099.

The federal income tax is progressive: rates rise in brackets as taxable income rises, and each rate applies only to the income within its bracket, so your marginal tax rate is higher than your effective (average) rate. Taxable income equals gross income minus deductions; most people take the standard deduction rather than itemizing. Tax credits reduce the tax owed dollar for dollar and are worth more than deductions of the same amount. Taxpayers file a return (Form 1040) by the April deadline; if more was withheld than owed, they get a refund, and if less, they owe the difference. Other taxes include sales tax, property tax and excise taxes.

A worker who owed no federal income tax last year and expects to owe none this year can claim "exempt" on the W-4, so no federal income tax is withheld. Social Security and Medicare (FICA) taxes are still withheld from every paycheck. Claiming dependents on the W-4 and the tax return lowers the tax owed, mainly through credits such as the Child Tax Credit, so less is withheld from each paycheck.

Taxes pay for public goods and services such as roads, schools, police and fire protection, national defense, and programs like Social Security and Medicare. A progressive tax takes a larger share of income as income rises. A proportional (flat) tax takes the same share from everyone. A regressive tax, like a sales tax, takes a larger share of income from lower earners. Self-employed and gig workers pay self-employment tax, which covers both the employee and employer shares of Social Security and Medicare. Because no employer withholds their taxes, they usually make quarterly estimated tax payments to the IRS.

An entrepreneur starts and runs a business, taking on the risk of losing money in exchange for the chance to earn profit. Owners keep the profits but also absorb the losses, and many start as sole proprietors.

Key ideas

• Education and skills (human capital) raise earning potential.
• Gross pay minus deductions equals net pay.
• FICA taxes fund Social Security and Medicare.
• Federal income tax is progressive, with marginal brackets.
• Tax credits reduce taxes more than deductions of the same amount.

Formulas and rules

Common mistakes

• Thinking moving into a higher bracket taxes all your income at the higher rate; only the income in that bracket is.
• Confusing a deduction (lowers taxable income) with a credit (lowers tax owed).

Words to know

Human capital

Skills and knowledge that increase earning potential.

Gross pay

Earnings before any deductions.

Net pay

Take-home pay after deductions.

Salary

A fixed yearly amount of pay.

Wage

Pay based on hours worked.

Employee benefits

Non-wage compensation like health insurance and retirement matching.

FICA

Payroll taxes for Social Security and Medicare.

Withholding

Tax taken from each paycheck in advance.

Form W-4

Form an employee fills out to set tax withholding.

Form W-2

Annual form showing wages and taxes withheld.

Form 1099

Form reporting income for independent contractors.

Progressive tax

A tax whose rate rises as income rises.

Marginal tax rate

The rate on your last dollar of income.

Effective tax rate

Total tax divided by total income.

Standard deduction

A fixed amount that reduces taxable income.

Tax credit

A dollar-for-dollar reduction in tax owed.

Tax refund

Money returned when too much tax was withheld.

Sample practice questions

13 more questions like these, from level 1 to 5, are in the practice set.