Taxes suck. No one wants to pay them but as members of society, we’re kinda stuck. But how do taxes work? Here’s a breakdown on tax brackets, deductions, and more.
Do you ever think?
- If I pay taxes out of every paycheck, how come I have to file again every spring?
- What even is a tax bracket?
- How come billionaires pay way less in taxes than normal people?
- How can I pay less taxes as a “normal” person
Taxes are totally not the most exciting topic, but it’s something that, as adults, we should all at least try to understand the basics. So let’s dive in and I’ll break it down for you, Taco Style.
How is money taken out of a paycheck?
When you are first hired, your new employer has you fill out a form called a W-4. On this form, you tell your employer:
- How many people you claim on your taxes.
- Are you married?
- Do you have kids, if so, how many?
- Are you still claimed by your parents?
With this information, your employer figures out how much of your check to withhold based on your pay, then they pre-pay your taxes for you.
There’s also a place on the W-4 form to request that extra taxes be withheld in addition to your employer’s calculated amount.
- Maybe you have a side job and earn extra money as an independent contractor
- Your spouse has a side job
- You don’t want to deal with paying monthly or quarterly taxes from that side job
You can request that the taxes owed from that other income be taken out of your regular paycheck ahead of time.
If you constantly end up owing large amounts of taxes in the spring, talk to your HR department and update your W-4 form to withhold more from your paycheck.
If you always end up with huge refunds, you can update your W-4 form to have less taken out of every check, giving you more money for living expenses or to put away in savings. But if you like that extra bonus in the spring and think of it as forced savings, just leave it alone and enjoy the windfall.
- Always owe in April? → Have more taken out of every check
- Always have a huge refund? → Have less taken out of every check OR just enjoy the extra bonus
Why do I have to do taxes every spring if it already comes out of my paycheck?
You filled out your W-4 form and paid your taxes all year via your employer, the government should just take the money and be happy right? But actually, Uncle Sam and the bureaucrats out East, as much as they want your money, want the country to be successful too.
There are certain behaviors that are encouraged in the form of tax breaks. If you do things that the government thinks is good for the country, you will be given a tax break.
- Grow the population by having kids? You get a tax break!
- Continue the American Dream by taking out a mortgage and buying a house? You get a tax break!
- Put solar panels on that house to make more green energy? You get a tax break! (well at least in certain places)
- Make the country better educated by taking out a loan and going to college? You get a tax break!
- Start a business to keep the economy growing and people employed? You get a tax break! (but you still have to pay your self-employment taxes)
- And best of all, put money into a retirement account for your future self so you won’t cost the government so much money for care in your elderly years? You get a tax break!
Spring tax season is your time to tell Uncle Sam all the cool things you did for the country so that he’ll give you tax breaks!
So what are these tax breaks?
Standard Deduction
Tax breaks bring down your amount of “taxable income.” Everyone is offered a standard deduction on their taxes.
The standard deduction is the amount the government believes you need to live, so they agree not to tax you on this amount. Like everything in the tax code, the standard deduction changes often and is affected by inflation. But if the standard deduction is $12,500, like it is for 2021, and you make less than that for the year, you shouldn’t owe any taxes and will probably get a refund for whatever you pre-paid throughout the year!
Standard Deduction- Automatic deduction, offered to everyone, every year
In addition to the standard deduction, there are 2 different types of tax breaks: credits and deductions.
Deductions
Deductions- deductions are things that you can use to lower your taxable income
- If they push your taxable income below $0, you won’t get anything extra back, just whatever your employer prepaid for you.
- Usually for things that are encouraged but wouldn’t cause you any harm if they didn’t happen. Things like:
- Property taxes
- Mortgage interest payments
- Charitable donations
- Medical expenses
Credits
Credits- credits are also things that you can use to lower your taxable income
- If they push your taxable income below $0, you actually get that money back in addition to whatever taxes your employer prepaid for you!
- Credits are mightier than deduction
- Usually, things that are important to your well-being. Common tax credits are:
- Child/adoption tax credit
- Disability tax credit
- Retirement savings credit
- Health coverage credits for ACA plans
- Low-income tax credits
How do tax brackets work?
We all know Uncle Sam wants his money, but he also realizes that the less you make, the less you are able to play to help your country! Thus tax brackets were made.
Again, like everything else in the tax codes, tax brackets change often depending on how the president and congress are feeling that year.
For 2021 the tax brackets look like this:
Now, many people do not fully seem to grasp the way tax brackets work. They think that whatever tax bracket their income falls in, they are responsible for paying that amount on their whole income, that is a mistake!
The tax bracket works like a ladder. You go through each step on your way up, not just jump to the top rung you can reach.
- For the first rung of your salary, you pay that percentage
- For the second rung, you pay that percentage
- And so on.
- Then add each rung up for your final tax bill
So there’s not some gigantic tax bill looming in the distance just because you get a raise at work. You will probably pay more, yes, because you will make more, but you won’t pay more on what you’ve already been making.
Why do some people who make way more than me, pay way less in taxes?
People like Jeff Bezos and Trump, who make millions or billions and proudly claim they pay no taxes often do it completely legally.
They do exactly what the tax code encourages:
- Run businesses
- Employ people
- Own property
- Invest
All these things are supposed to help the country grow and are thus encouraged via deductions. But huge business owners aren’t the only ones who can bring down their tax bills, you can too!
Easiest ways to bring down your own tax bill.
One of the easiest ways to bring your own tax bill down, and keep the money for yourself, is to invest in your retirement accounts.
Put your money into pre-tax retirement accounts
By taking pre-tax dollars out of your regular paycheck and putting it in a traditional 401k, TSP, 403b, IRA, etc. you are lowering your taxable income while keeping the money for your future self.
The maximum amount you can put into a retirement account in 2021 is
- $19,500 per person in an employer-sponsored plan
- An additional $6,000 in an IRA (individual retirement account)
- $26,000 and $7,000 if you’re over 50
If you were to max out both your employer and IRA retirement accounts, you can bring your taxable income down by $25,500! That could easily bring you down a whole tax bracket!
And if you have a spouse, they can do the same, bringing down your taxable income by twice as much! (So long you can live on that amount.)
Put your money into medical savings accounts
Another simple way to bring down your taxable income, if you have access to them, is by contributing to a Flex Spending Account (FSA) or Health Savings Account (HSA). These are accounts that let you put pre-tax money away for medical expenses. But you have to check with your employer to see if they offer an FSA or HSA. not all companies do.
Sample Tax Situation
Here is a sample of how you can save money in taxes by putting money away in retirement funds:
Anna makes $60,000 but because of her standard deduction, retirement contributions, and child tax credit, she is only taxed on about half of her actual salary!
Instead of running her full $60,000 through the tax bracket ladder, she only has to run her Taxable Income of $33,500 and ends up with a tax bill of only 6.4% of her $60,000 income! Not the 22% so many people believe she will pay.
Wrap Up
In summary, taxes suck. Nobody likes them, everybody hates them, I wish they’d go eat some worms. But if you understand how they work, it’s a lot less intimidating and easier to find credits and deductions to bring your own tax bill down.
So please, pay your taxes on time, don’t make your accountant/tax preparer (even if it’s yourself) freak out with last minute filings. It all took place in the previous year, so no matter how long you wait now, it won’t make much of a difference, unless it’s adding money to an IRA before the tax cutoff, because that’s actually allowed. So make sure to take advantage of every legal tax break you can get and fill up your retirement accounts!
Whew, hope that helps and you didn’t fall asleep.
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I love the simple break down for taxes