Nobody forgets the first time, whether it was at their high school job at the ice cream parlor or their first job out of college, that they eagerly tore open a paycheck, already planning a shopping spree… only to find that someone had stolen a huge chunk of their money! (If you haven’t felt this sinking feeling yet, prepare yourself.)
Yup, that big missing chunk went to taxes. But don’t think you’re not getting anything for it! Here are a few examples of what your taxes get you: the clean water running out of your tap, the police keeping your neighborhood safe and the garbage that gets picked up on your curbside.
We’re sure you have an opinion on whether you’re over or underpaying the government, but that’s a topic for another time. Today, we’re going to explain to you the ins and outs of taxes so you can fully understand how they affect your finances.
Taxes in a Nutshell
Taxes are compulsory contributions to the state you live in, and to the federal government, levied by the government to pay for things that we as a society need but can’t pay for individually. That includes everything from the roads you drive on to law enforcement to the salary of the President of the United States.
These taxes aren’t optional, and trying to hide or outrun them never really ends well. (Don’t believe us? Just Google “celebrity tax evasion.”) Plus, 96% of Americans believe it’s your civic duty to pay taxes, so the best thing to do is get a basic understanding of taxes so that you can pay them accurately and on time, with minimum stress and pain—financial or emotional.
Why Understanding Taxes Is Important
Understanding taxes will save you when filing. Collectively, Americans overpay the government by $945 million every year. That’s about $400 per household. If you understand how taxes work, you can avoid giving too much to Uncle Sam.
Understanding taxes will also save you at work. At your job, understanding how taxes work can help you save hundreds on transportation costs or childcare by having your costs of getting to work or having your children take care of taken out of your paycheck pre-tax. But more on that below.
Understanding taxes will also help you budget better. You’ll be able to more accurately plan your monthly and yearly spending if you understand how much you’ll be paying. No one likes financial surprises (unless it’s a giant windfall).
How Taxes Work
When you pay taxes, the money goes to the coffers of the local, state and federal governments. That money is then pooled and allocated to various services and projects, ranging from regulatory agencies that ensure your medicines are safe and that your roads aren't filled with potholes.
The tax system is complicated, but many of the regulations are there to incentivize you to save and spend wisely. For example, if you take money out of your 401(k) for anything besides retirement (not good!), the government will punish you by levying a tax penalty on top of ordinary taxes. But if you decide to donate a lot to charity, the government will reward you by lowering your tax bill.
n. The amount taken out of each paycheck in order to pay your income tax incrementally over the year. You designate exactly what your withholding will be when you fill out your W-4 form at your job.
n. Kind of like a tax discount, this is a dollar amount subtracted from your taxable income; it reduces how much you will be taxed on.
n. The Internal Revenue Service. This is the government agency responsible for collecting taxes from you and businesses.
n. Profit from investments into a capital asset, such as stocks, bonds or real estate. It’s the difference between a higher selling price and a lower purchase price. For example, if you buy a stock for $10 and sell it for $20, you made a capital gain of $10.
The Most Common Types of Taxes
There are many types of taxes, but here are the ones you will almost definitely come across:
Payroll Tax: This is everything that is taken out of your paycheck. It includes federal and state income taxes, Social Security Tax Withholding and Medicare Tax Withholding and various local taxes, which may include city, county, or school district taxes and state disability/unemployment insurance.
Income Tax: This is a tax on the amount you earn every year paid to the federal and state government. If you have a salaried job, this amount is withheld from each paycheck. Then at the end of the year, you calculate how much you should owe for the year and either the government refunds you because you’ve already paid too much, or you pay the government if too little was taken out.
If you are a freelancer, you should pay quarterly taxesEstimated taxes that you pay every quarter, by the 15th of every April, June, September and January, for the previous tax year. This is a lot like withholding, so you don’t get one huge tax bill in April..
If not, the responsibility is on you to pay what you owe in full (which can include a non-payment penalty) in April. If you make more than $1,000 per year in freelance income, we suggest putting at least 30% of your income into a special savings account and checking in with your tax advisor as soon as possible to make sure you’re setting aside the right amount. Learn more about taxes for freelancers.
Sales tax: Levied by your state government, you pay this almost every time you buy something. (Unless you live in Delaware, Alaska, Montana, New Hampshire or Oregon, which have no sales tax.) It ranges from 8.75% in California to 4% in Hawaii. You’ll see what you pay in sales tax on your receipt at restaurants or from retailers. Once you’ve paid, you’ve paid, and you don’t need to worry any more about this tax.
Capital gains tax: This tax is specifically based on what you made off of your investments this year. If you bought a stock for $80 and sold it for $100, the government will tax you on the $20 you made. If you sell this investment before you’ve held it for an entire year, then you’ll have to pay ordinary income tax (i.e. short term capital gains). To encourage long-term investing, the government has made it possible for you to qualify for the lower long-term capital gains taxes if you hang onto the investment for a year or longer. You pay these with other taxes in April.
Property tax: This tax is on the value of your home and the property it sits on, or other properties you might have, like a mountain cabin. You’ll be taxed every year whether or not you own it free and clear or you’re still paying the mortgage—as long as your name is on the deed, the tax man cometh. This tax is paid to the local government, and usually goes to local schools, law enforcement, roads and more. You pay this tax semi-annually and often it is included (impounded) in your monthly mortgage payments so you don’t have to cough up the funds in a lump sum in April.
What You Can Do About Your Taxes Now
So now that you know how taxes work, you’re probably wondering: What the heck do I do? These are the general principles you should follow to make sure you pay just what you need to—no more—and that doing taxes is as painless as possible.
1. Get your withholding (or your quarterly taxes) right.
As mentioned earlier, a portion of each paycheck you receive is withheld to pay for taxes. (That portion is, logically, called your withholding.) While you might miss that money, the upside to withholdings is that taking a little bit throughout the year is much less painful than having to pay $5,000 or more in taxes all at once!
If you have a salaried job, on your first day of work you fill out a W-4, which tells your company how much they should take out of each paycheck for taxes. If you fill it out wisely, you’re more likely to pay almost exactly what you owe in taxes—instead of paying too much or too little. And you shouldn’t hesitate to re-fill out your W-4 if your situation changes or you realize you’re withholding way too much or little. Learn how to fill out a W-4 here.
2. Get everything you can tax-free.
Your flow of money usually goes something like this: 1. You get paid. 2. You’re taxed on what you are paid. 3. You use the leftover money to buy things.
But for certain things like saving for retirement, paying for childcare, paying for medical expenses or buying a subway pass, you can use pretax income. That means if you send $1,000 from your paycheck to your 401(k), you won’t be taxed on that money. Hello tax savings! Read up on all the ways you can save on taxes here and get in on the game.
3. Stay organized.
The key to a relatively painless tax season is organization. Even if you have a tax preparer, she will charge you less if you hand her exactly what she needs neatly organized instead of dumping stacks of paper on her desk. Keeping track of your papers is especially important if you itemize your deductions. Here’s what you should save:
- Government confirmation of your return and your refund
- Records of charitable donations, including receipts
- Large medical or dental bills
- Records of business or job hunting costs
- Forms from your job showing income you’ve made
- Purchases, sales, and improvements to real estate property
- All actions in your investment and IRA accounts (Most online brokerages will keep these records for you.)
Taxes are complicated, we certainly can’t deny that. But millions of Americans like you file and pay them every year. Understanding the basics can help you save a lot of money over your lifetime, and save you stress too!