It’s the time of year again and tax season is almost here. Many Americans know very little about the US Tax Code and believe that it is very convoluted. In fact, NerdWallet conducted a basic 10 question tax quiz and discovered most respondents only answered 51% of the questions correctly. While the tax code has many intricacies, its fundamentals are relatively easy to understand. This post will help clarify some basic important tax concepts everybody should know. These concepts include tax brackets, types of deductions, credits, and tax refunds.
There are 7 tax brackets based on your income which includes salary, bonuses, commissions, passive income (i.e rental real estate) and portfolio income (think bond interest). These numbers are included in your gross income and it is important to use proper deductions to reduce your taxable income. For example, if you have a $1,000 deduction, it can move your income down a tax bracket. Thus, you will pay less taxes, which are why deductions are so important.
Types of deductions
There are many types of deductions but the main categories are above the line, standard, and itemized. First, you start with your gross income and you then subtract any above the line deductions like student loan interest and educator expenses to reach your AGI, or Adjusted gross income. Another important above the line deduction is one half of the self-employment tax for self-employed individuals. In addition to paying federal and state taxes, you also pay Social Security and Medicare taxes. These taxes fund these programs and employees pay one half of the total taxes, while employers pay the other half. Self-employed individuals have no employer and must pay the entire percentage (15.3%), but half of the tax can be used as an above the line deduction.
There are five filing statuses which are single, married filing jointly, head of household, qualified widower and married filing separately. Based on your filing status, you are entitled to a standard deduction of $6,300 for Singles up to $12,600 for Married Filing Jointly. It is important to know that you can’t have a standard deduction and itemized deductions, but must choose the larger of the two.
Itemized deductions can significantly decrease your tax burden and include medical/dental expenses, charitable donations, property taxes, mortgage interest, state taxes, and miscellaneous deductions. Also, there are certain limitations for taking these deductions, which are based on your AGI. For example, you can only tax deductions for medical/dental expenses that exceed 10% of your AGI. In most cases, you can only deduct charitable donations that are worth up to 50% of you AGI. There are some other cases that allow up to only 30% AGI and you can learn more here.
While deductions are important, credits can further mitigate tax liabilities. Some credits include home energy credits and earned income tax credits. While deductions reduce your taxable income, credits reduce your income dollar for dollar. For example, a $1,000 tax credit saves you $1,000 in taxes while tax deductions only lower your taxable income and are equal to the percentage in your marginal tax bracket. For example, if you are in the 25% tax bracket, a $1,000 deduction only saves you $250 in tax (0.25 x $1,000 = $250).
Are refunds as great as they seem?
Every tax season, each major preparation service bombards us with claims that they can get you a healthy tax refund in little time. While it is better to have a refund than owe a large balance, the ideal scenario would be a break-even situation. If you receive a tax refund, all that means is you over-withheld on your paycheck and gave the government an interest free loan. That money could have been saved towards a future goal or invested to give you a solid return. In addition, the government can delay returns, thus increasing your missed opportunities to save and invest.
How to achieve a break-even situation
One way you can ensure a break-even situation come tax time is to adjust your W-4. The government has a plethora of forms, but the W-4 controls your allowances or how much your employer can withhold from your paycheck. The more allowances you have, less money is withheld for taxes, while less allowances mean more money is withheld. Fortunately, you can adjust your W-4 throughout the year and this tool will help you guide will show you how.
We covered sufficient ground in the article and we hope you enjoyed it! By now you should have a fundamental understanding of the US tax code and hopefully use efficient tax planning strategies. Do you know of other basic tax concepts, everybody should know? If so, please post below!