Breaking Down Tax Basics for Beginners
Welcome to the world of taxes! If you’re new to this and feeling a bit overwhelmed, don’t fret. We’re here to break it down for you in simple and understandable terms. By the end of this blog post, you’ll have a solid grasp on the basics of taxes and how they affect your income.
Understanding What Taxes Are and Why We Pay Them
Delving into the tax universe, we find that taxes are essentially contributions that individuals and businesses make to the government’s treasury. These contributions play a vital role as they serve as the government’s lifeblood, fueling various public services and projects that we often take for granted. This includes our schools, healthcare systems, the roads we travel on, and the defense mechanisms that protect our nation.
Now let’s imagine a world where there are no taxes. The government would come to a standstill, unable to function or provide these necessary services. Now, every one of us has a part in this and contributes to the taxes in some way or another. Therefore, it’s beneficial to familiarize ourselves with the fundamental mechanics of taxes and how they impact our financial health.
Different Types of Taxes
As you journey through the tax landscape, you’re bound to stumble upon various forms of taxes, each with its own unique attributes and impact on your financial well-being. Let’s go over the most common ones.
1. **Income Tax**: This tax is levied on your earnings. Every paycheck you receive will have a portion deducted for federal, state, and sometimes local income taxes.
It’s interesting to note, that not every state has a state income tax. As of 2023 those states are: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. States without a state income tax will usually make it up another way like having a higher sales tax or higher property taxes.
2. **Sales Tax**: Ever noticed an additional charge when you purchase a product or service? That’s sales tax. It varies by state and even by cities within those states.
3. **Property Tax**: If you’re a homeowner, property tax is an unavoidable part of your life. This tax, based on the value of your property, funds local services like schools, libraries, and public safety.
4. **Payroll Tax**: If you’re an employee, you’ll see deductions for Social Security and Medicare on your pay stub. These are payroll taxes, and they fund these vital social programs.
5. **Capital Gains Tax**: Make money from selling an investment or property? You’ll likely owe capital gains tax on the profit.
6. **Estate Tax**: Also known as the “death tax,” estate tax applies to the transfer of an estate after someone passes away.
These are just a few examples of the types of taxes that you might come across in your day-to-day life. Each tax serves a different purpose and helps keep our society running smoothly. The more you understand about these taxes, the better equipped you’ll be to plan your finances effectively.
How Income Tax Works
Now let’s dive into the workings of income tax. In the U.S., our income tax system is designed to be progressive, which essentially means that as your earnings increase, so does the percentage of your income that you owe in taxes. Now, don’t let your heart race just yet. It’s not as daunting as it sounds!
Here’s the thing: there are seven distinct income tax brackets, and they range from 10% at the lower end to a maximum of 37% at the upper end. However, it’s crucial to keep in mind that not all of your income is taxed at the same rate. In fact, your income is divided into chunks, each of which falls into a specific tax bracket and is taxed at the corresponding rate.
For instance, if you’re a single filer and your income in 2021 is $50,000, the first $9,950 is taxed at 10%, the next chunk up to $40,525 is taxed at 12%, and the remaining amount over $40,525 is taxed at 22%.
This system, while it might sound a bit complex at first, ensures that those with lower incomes aren’t overly burdened by taxes. It’s a vital piece of our tax structure, designed with the intent of creating a fair and equitable system.
So, as you navigate the tax waters and plan your financial future, understanding the mechanics of income tax can be a valuable asset. With this knowledge, you can budget more effectively, strategize your financial growth, and ultimately, cultivate a sense of control over your hard-earned money.
How to Prepare for Tax Season
There are many people that get really anxious when thinking about taxes. Taxes can very quickly become complicated if you don’t know what you are doing. But not to worry – the key to a stress-free tax season is preparation. When you’re well-prepared, those daunting tax forms become a lot less intimidating.
Kick off your preparation by gathering all the essential tax documents. These include W-2 forms from your employers, 1099 forms for any freelance or contract work, and receipts for tax-deductible expenses. Start collecting these documents as soon as they start rolling in and keep them organized. This way, when tax season is in full swing, you won’t be scrambling around looking for that one elusive document.
You can start collecting tax documents usually at the end of January. Please note that the timeframes that companies release tax documents are all different. So, it may take you several weeks to a couple months to finally collect all the documents you need to file for your tax return.
Next, you’ll need to make an important decision: will you be taking the standard deduction or itemizing your deductions? Both have their benefits and drawbacks, and your choice can significantly impact your tax bill. A bit of research and consideration can help you determine the best option for your situation.
A standard deduction is a fixed dollar amount that reduces income you’re taxed on. It is also the most common type of deduction people take. A standard deduction:
- Allows you to take a tax deduction even if you have no expenses that qualify for claiming itemized deductions
- Eliminates the need for itemizing deductions and
- Allows you to avoid keeping records and receipts of your expenses in case of a tax audit
Unlike the standard deduction which is a fixed amount an itemized deduction is a dollar-for-dollar deduction that differs from taxpayer to taxpayer. The itemized deduction amount is determined by adding all applicable deductions and subtracting the sum from your taxable income.
In other words, itemized deductions are specific types of expenses the taxpayer incurred that may reduce taxable income. Some common itemized deductions are:
- Casualty and theft losses from a federally declared disaster
- Charitable donations
- Deduction for state and local taxes
- Gambling loss deduction (only to extent of gambling winnings reported on your tax return)
- Home mortgage interest and
- Unreimbursed medical and dental expenses (AGI threshold is 7.5%), including health insurance premiums paid with after-tax income
It’s important to note you can claim whichever deduction reduces your tax bill the most. However, you can claim only one – you can’t claim both.
Finally, the last big decision is whether to fly solo or hire a tax pro. Filing your taxes yourself can save you some money but if your tax situation is complicated, the cost of a professional might be worth it for the peace of mind.
Remember, a journey of a thousand miles begins with a single step. Even though preparing for tax season might feel like a marathon, taking it one step at a time can make the process a lot less overwhelming. Get started early, stay organized, and before you know it, you’ll be crossing the finish line with your taxes filed and a sigh of relief.
Seeking Professional Help
Many people do not enjoy doing taxes and every person’s taxes are unique to them. Some people’s taxes are very simple, and others may be very complex. If doing taxes on your own stresses you out or you would rather have help, then that’s okay! There are professionals here to help us all for that very reason.
Tax professionals are fluent in the language of tax law and will ensure your return is filed with the utmost accuracy. Some common places to go in-person to do your taxes are H&R Block and TurboTax. Both of these places also offer online assistance if you’d rather have professional help from the comfort of home.
However, if you choose in-person or online assistance it isn’t free – it will come at a cost. The cost of assistance will be paid out pocket, or out of your tax refund – whatever you decide. It may seem silly that this assistance isn’t free, but they are professionals for a reason and will do their best to help you out.
Not everyone will need professional tax help, but if you find yourself in a complex tax scenario, their expertise can be invaluable. Let’s say you’re an entrepreneur, with your own flourishing business. Or perhaps you’re an avid investor, with a diversified portfolio that’s a source of significant income. Maybe you’re even tangled up in an audit. All these situations scream for the expertise of a tax professional who can help you negotiate your way through the tax terrain.
So, don’t be shy about seeking professional help if you need it. It might cost you a bit, but when you weigh that against the peace of mind and potential tax savings they can bring, it’s worth it. It will also save you a lot of time and stress. However, do what you think is best for you. If you feel confident in doing your own taxes or have family that can help you out – then go for it! The only way to get better at something is to try it out yourself first. If you try to do it first and need help later, then ask for help.
Hopefully this was a little eye-opener into the world of taxes. This article tries to cover the very basics of taxes and their purpose.
Thanks for reading. If you have any questions, you can email me at: nichole@financialfloofs.com
See you next time!
