The hardest thing in the world to understand is income tax.
All You Need To Know
Not really, Al. And you really don’t need to understand taxes, just know how to calculate them, not overpay them, what you are actually paying, and how to reduce them.
The key to taxes is knowing how to fill out forms. The first tax form when you go to work is the W-2. If you had any kind of job in high school or college, you already have done one. The next form is the tax return itself that most people think is hard and thus go to H&R Block but for someone like you making a straight salary, it is easy. Google tax forms or go to IRS.com and they pop up. Download the 1040EZ or the regular 1040, follow line to line and pay up by April 15.
Most people think that rich people find a way around taxes. They don’t, at least not legally. Right now you can reduce your taxes in only a few ways and they are 1) retirement plans like your 401(k) or IRA, 2) medical insurance deductions or 3) mortgage interest. The best way to reduce your taxes is to own your own business but that’s not an option right now.
So what is the purpose of this chapter? To understand and feel the pain of taxes. If you don’t want to, quit reading now. If you at least want to understand, Einstein not withstanding, the tax system in a bit more detail, keep going.
Doing the form yourself instead of some moron at H&R Block (I don’t want to sound dismissive but, for some reason not to be discussed here, I took the H&R Block training course and it is scary-if you think these people know more than you, think again.) makes you see where your dollars go and just how many dollars YOU earned are not going to you.
The tax code is progressive as opposed to regressive. A regressive tax is one that costs the same for everybody-a day laborer pays the same for a car registration as Bill Gates. A progressive tax means the more you make, the more you pay. Bill Gates makes more than a day laborer so he pays more. Sounds fair until it is applied to you.
Here are the tax brackets for a single wage earner.
Income Tax Rate
Up to $7,150 10%
Between $7,150 and $29,050 15%
Over $29,050 25%
It gets worse but let’s concentrate on this now and the lesson is that for every dollar (after confusing things like the standard deduction) you make over $7,150 you pay 15 cents to Uncle Sam. For every dollar over $29,050 you keep 75 cents and Washington gets 25 cents. In business this is known as the marginal tax rate, the percentage rate paid on the next dollar of income. Put another way, this means you are working from January 1 until March 31st for the United States Government. Think about it. Then add on top of this the FICA tax and Medicare and state and local taxes. Ouch.
As noted, the first step in tax planning is the W-2 you fill out at work. Follow the instructions. You will probably take one or two exemptions. When in doubt, take one. Don’t put zero which will result in greater withholding which will lead to a big refund which lots of people love but is really DUMB because you are making a 12 month, interest free loan to the same guys that are taxing you, the US government. Instead take one or two exemptions and direct your bank or mutual fund like Vanguard or Fidelity to directly debit your bank account, say $50 a month, and put it in a money market account or savings account. The net result is that you have the money, not the government.
People are scared to death of doing their own taxes. They shouldn’t be as the forms at your level of income are pretty easy and you won’t miss anything if you follow instructions closely except a fee paid to H&R Block. Google tax forms or IRS.com and download the 1040’s and start.
If you get hung up, go to Best Buy, Staples, Office Depot or any other place that sells software and pay between $10 and $20 for a program like TurboTax by Intuit or TaxCut by none other than, H&R Block. It’s an interview type program and will automatically alert you to any breaks you might have coming.
It will be pretty easy and you will see where your money goes and how much is going. The forms and programs will also alert you to the savings of a 401(k) or IRA and anything else you may qualify for in the way of tax relief. But don’t count on much. The program will save you about $50 to $100 in tax preparer fees. You will also feel a little more in control of the system and you can flaunt it at work. Or you can do the same for friends and colleagues and make some money as a tax preparer as there is no certificate or training needed to do tax returns for money.
The tax code is progressive which means the more you make, the more you pay. It wasn’t always that way. Prior to 1913 and with the exception of periods of crisis such as the Civil War, there was no income tax. The government was funded by tariffs on imports (which encouraged smuggling) and ‘sin’ taxes on tobacco and alcohol. For some reason, Congress passed and the states ratified the income tax system in 1913.
The big change in the system came in 1943 when, in an attempt to improve collections, they came up with the withholding tax. The employer takes the tax out of your paycheck and sends the money to the Internal Revenue Service. You don’t see it so the pain is not felt. Can you imagine sitting down and writing a $300 check to the government every month? I don’t think so. The guy you have to thank for the idea was the then chairman of JC Penney so think about that the next time you are at the mall.
So, how much is being withheld? As we said, you are paying 10% for every dollar earned under $7,150 adjusted for details like the standard deduction that you will learn about when you do your return. The rate is 15% on every dollar earned between $7,150 and $29,050 and 25% on every dollar over $29,050. That really hurts. Then add in FICA and Medicare and there goes another $2,600 or so a year on a $35,000 salary. And then state tax which is everywhere except for six or seven states like Texas, New Hampshire, Florida and a couple others I can’t remember right now. On top of that add the regressive taxes like sales tax and taxes on your cell phone—take a look at your bill next month and see what that is costing you.
Finally, this is after Bush cut taxes. It was even more before he got the rates lowered. This is also why people in the private (for profit companies) sector want tax reduction and people in the public sector (government employees and mayors and politicians) don’t want tax cuts because that cuts down on money going to them. But enough of theory. What can you do to reduce taxes? Not much but you can do something.
If you pay something (your employer picks up most of the cost) for medical insurance at work, your payments should be excluded from your taxable income. So if you make $35,000 and you are paying $1,000 a year in health insurance, your taxable income should be $34,000. A quick call to HR or Payroll will confirm.
If you have student loans and make less than $50,000 single, $100,000 married, you can deduct the interest, not the principal, on student loans. Turbo Tax or any other program will alert you to this.
The big winner when it comes to reducing taxes is the 401(k). If you invest 10% of your $35,000 salary in your company’s 401(k), your taxable income is reduced to $31,500. That’s a chunk. Go to Human Resources and get on this one. Most companies also have a match where they will put in money and ‘match’ your contribution.. If your company does not have a 401(k) consider changing companies. While doing so, invest in an IRA or Roth IRA. The details are in the section 12.
The other big tax reducer is mortgage interest but you aren’t at that stage yet so forget it for now. Also, remember that charitable contributions are NOT deductible unless you itemize which you can’t do right now. If you want to contribute to a charity, church or university, consider donating your time instead of money at this stage-it’s more meaningful for you and less expensive.
Finally, the ultimate tax break is YOUR own company. If you own your own company every expense, remember that, every expense is deductible because you are taxed on your net income (what’s left over after expenses) instead of being taxed now on your gross income (what you start with before expenses.) The tax code recognizes that business is risky and it rewards business owners for taking risks. So everything you use for business is deductible including automobile expenses, travel, entertainment up to a point, meals, even clothing in some cases. Look around—if your employer is providing free coffee and doughnuts, you can bet they are deducting the expense.
You want to own your own business someday anyway so plan ahead but for now check out your health care cost deduction, max out your 401(k) and think about a house. And, grit your teeth and pay the taxes.