Congratulations! On April 18th you have the honor of filing your taxes to formally pay the government. If you are a single taxpayer and have made more than $10,350 within the calendar year ending 12/31/16, you will pay some amount of federal taxes. Don’t worry though if you are in the same boat as many millennials, your tax bill will be minimal. If you are truly upset about how much you are paying in taxes, you must be working too hard.
Taxes are not all that high in the USA compared to many other countries. Yes of course if you are earning income and making a large sum of money it starts to hurt, but there are strategies to lower your tax bill. For all the complaining our generation does about the low wages they are able to earn starting their careers no one should be whining about taxes. To dive into this a little deeper let’s get a better understanding of how your FEDERAL tax bill works.
Important Tax Basics
To better understand how taxes work let’s take a look at the basics. The tax system for individuals is set up so that each dollar earned is taxed at a different rate. This is where the phrase “tax brackets” come from. One of the biggest misconceptions is when someone says “I don’t want to make more because I will be bumped up into the next tax bracket.” If you make enough to reach “the next tax bracket” it does not mean every dollar you earn will be taxed at a higher rate, the increased rate only applies to the amount you make over the previous bracket threshold. Let’s take a look at the 2016 income tax brackets and rates provided by the tax foundation. Also, we will take a look at the standard deduction and personal exemption.
The $10,350 stated earlier in the article for a single taxpayer can be found by adding the standard deduction and personal exemption. These are the amounts the government allows you to subtract from your gross income. After the $10,350 you make the next dollar you make will be taxed at the next brackets rate, this is referred to as the marginal tax rate. Looking at the table that means you will be taxed 10% on the next $9,275 you make. This means that if you make $19,625 you will pay $927.50 in taxes. The next level of income in tax bracket breaks would be if you make $48,000. Under this scenario, your highest marginal tax bracket would be 15%. This would lead to a tax bill of $5,183.75. Is this number higher or lower than you were expecting? If you are curious, you can use the chart above and see how much you will pay in taxes this year if you have your W-2 or 1099 handy.
Many people struggle with understanding taxes, but it is better to empower yourself with knowledge than to just complain year after year hoping that something gives. If you are savvy to how the system works, you can leverage it to your advantage. An important concept to take away is the difference between the marginal tax rate and your effective tax rate. The marginal tax rate once again is the amount of taxes you will pay on the next dollar earned, while the effective tax rate is your personal rate on your total income at the end of the year. For the example we used above, making $48,000 the effective tax rate would be 10.8% this is calculated by taking the amount you owe $5,183.75 and dividing it by $48,000. What do you think the fair tax rate is to pay when making $48,000 in America?
Other Ways to Lower Your Taxable Income
There are ways you can lower your taxable income and ultimately your tax bill. First, you have to make the decision to take the standard deduction or itemize. This is where you can lower your taxable income based on a set of rules allowing you to deduct other expenses you had throughout the year such as mortgage interest or interest payments on student debt. For most people, it makes sense to take the standard deduction because it is higher than if they were to try to itemize. This does not mean that itemizing never makes sense as it certainly does in certain situations; most young people use the standard deduction and don’t even know it through their online tax system.
Some Examples to Lower Income:
-Contribute to a traditional employee 401(K).
-Contribute to an HSA account.
-Contribute to a traditional IRA.
-Tax Loss Harvesting
Refunds and Why it is Okay to be Excited
Now that you are a tax expert let’s get to the fun part your refund! Let’s back up real quick, refunds are bittersweet, on one side if you are receiving a refund it means you have overpaid the government throughout the year, basically an interest-free loan, but on the other side it’s also a savings account that you can’t touch till you file and receive your refund. There are various factors that can change this depending on many situations, but the biggest for W-2 employees is how much is withheld in each paycheck throughout the year.
If you choose to have a higher withholding and receive less in your paycheck, then you will get a bigger refund come tax time. Vice Versa if you decide to have a larger paycheck during the year you might end up owing a certain amount to the government. Many argue about what is the right withholding amount and say it is better to get more money in your paycheck sooner so you can invest these funds. I would argue that the majority of people who let money flow through to their pocket let it flow out of their wallet and never end up investing it at all. Instead, sometimes I think getting a refund to many psychologically can be a positive. They can understand that seeing the money all together it is a decent chunk of change and reconsider blowing it and use it to better their life instead.
What Are Your Thoughts?
- Do you think we pay too much in this country for taxes?
- Is it important that we educate ourselves about the tax system?
- Would you leave your country to flee for a lower tax rate like many corporations do?