Does the word “tax” make you want to take a nap?
Yeah, me too. But taxes are an important part of your financial picture, and one that is often overlooked. Paying close attention to all aspects of your tax picture — from how much is being withheld from your paychecks to which credits and deductions you qualify for — can either save (or lose) you thousands of dollars over the years.
After this crash course, you will be able to understand the basics of how taxes work, and how to make the tax code work for you (or at least not against you).
Make sure the right amount is coming out of your paycheck.
At tax time, do you usually get a sizeable refund? Or are you faced with a big bill? Ideally, you should come up about even — neither owing nor getting back a large chunk of change. No one likes having to pay up, of course, but getting a refund also isn’t really a good thing.
Paying more than you’re due in taxes — which results in a big refund — is like giving Uncle Sam a free loan. If you had invested that money instead, you could have earned some extra cash in returns.
How much money you get back (or owe) at tax time is determined by how much is being withheld from your paychecks. If you get a refund, you’re having too much withheld, and if you owe taxes, you’re not having enough withheld.
How much comes out of your paycheck to cover taxes is determined by how much you make and the information you provide on the W-4 tax form you fill out when you start a new job.
If you’ve had too much or too little withheld from your paycheck in the past, or if you experience a life change like marriage or the birth of a child, check out the IRS’s Withholding Calculator to get a better idea of how you should fill out your W-4.
Deductions vs. Credits
Deductions and credits are two factors that can reduce your tax liability, and thus how much you pay. However, they reduce what you owe in different ways.
As you probably know, you don’t pay taxes on the entirety of your income, just on your taxable income. Deductions save you money by reducing the portion of your income that you’re taxed on.
The way you approach tax deductions relies heavily on whether you choose to take the standard deduction or itemize.
If your financial situation is simple, you may just want to take the standard deduction — it’s much easier and less time consuming than itemizing. However, if you have large medical expenses, make significant financial charitable donations, or are making interest payments on a mortgage, you may want to itemize. If you are itemizing your deduction, it may be a good bet to enlist the help of an accountant.
The other factor that influences how much you’ll pay in taxes is the number of credits you’re eligible for. Credits directly reduce the dollar amount of taxes you owe. Therefore, they affect all taxpayers equally, regardless of tax bracket.
Tax Brackets, Demystified
Your tax bracket determines the rate at which your income is taxed. It’s part of our country’s progressive tax system, wherein people with higher incomes pay taxes at a higher rate than those who make less.
Once you pass a certain set income threshold, you fall into the next tax bracket. Therefore, you may assume that all of your taxable income is taxed at the rate dictated by your tax bracket — but that’s not how it works.
Instead, your income is taxed in segments. For example, using the figures the IRS has announced for the 2014 taxes you’ll file in 2015:
- The first $9,075 of your income will be taxed at 10%
- Any income you make over $9,075 up to $36,900 will be taxed at 15%
- Any income you make over $36,900 up to $89,350 will be taxed at 25%
- Any income you make over $89,350 up to $186,350 will be taxed at 28%
- Any income you make over $186,350 up to $405,100 will be taxed at 33%
And so on.
You’ll notice that the amount you pay in taxes builds as income increases, and that tax percentages don’t increase at uniform intervals as they go up. In this way, tax brackets are more like steps than a ladder.
When To Enlist Help
If the prospect of tackling your taxes is still making your head spin, you may be tempted to get some help. The good news is, you don’t have to go it alone.
If you are planning to take the standard deduction, there are plenty of affordable tax software options that will take you through the process step by step. These programs can often also handle simpler itemized deductions, too.
However, if you’re part of a business partnership, exercised stock options that year, are a freelancer, have substantial investment income or losses, went through significant life changes, or worked overseas, you may want to spring for a meeting with an accountant. He or she can ensure that you take advantage of all the credits and deductions you’re entitled, and that the most money possible stays in your pocket, where it belongs.
Make sure to check out the other articles in the series, 5 Financial Must-Haves for Gen X and Gen Y.