How To Buy Stuff

How To Buy Stuff: Pay Your Taxes

The Mitochondria is the Powerhouse of the Cell.

I read a lot of Reddit, for better or worse. One running joke is that High School didn’t teach people anything useful, like how to “pay bills or do taxes” (these are two common things people say they never learned), but they learned the above statement. It’s a meme. Reddit’s kinda dumb, now that I think about it.

But this idea always sticks with me, because, well, high school absolutely did teach you how to do those things. Maybe not directly, but reading directions and doing some basic math is a corollary concept of everything you did in High School. Taxes are, for 99% of people, a very simple task they have to complete once a year. Doing your taxes often results in a tax refund, as well, so it fits in with How To Buy Stuff.

But, since so many people complain about not understanding taxes, lets do this.

Lets Talk Tax Law!

The tax code itself is a ridiculously long book of rules and regulations. I think this is probably what people think of when they get overwhelmed and say they “don’t know how they do their taxes”. But you don’t really need to know what’s in most of that book.

There’s 3 parts to the tax code. Part 1 is basically one sentence:

Part 1: All Income is Taxable.

This is pretty straight forward. Any money you make during the year is subject to be taxed as income. Now, you’re going to say “but what about…”, and we’ll get to all those questions a little later, but for now, all the money you make is supposed to be reported and taxed. On to Part 2:

Part 2: Tax Brackets

The second section describes how much taxes you should be paying, and lays out the dreaded tax brackets that cause a ton of confusion. The actual numbers where the brackets start and end can change year over year, so I’m going to use general numbers to describe this, but the first misconception that we need to clear up: You Are Not In a Tax Bracket. The money you earn gets set in tax brackets, not yourself. What the hell does that mean?

So, lets set out 3 hypothetical tax brackets. We’ll name them Level 1, 2, and 3 (because I’m creative).

  • Level 1: $0-25,000 – 10%
  • Level 2: $25,001-$50,000 – 15%
  • Level 3: $50,000 and up – 20%

So lets say you make $55,000 per year, before taxes. You’re in level 3, so you might expect that you’d pay $11,000 in taxes (20% of $55,000), but that’s not right. Remember, you are not in a tax bracket, the dollars are. You’ll pay:

  1. Level 1 dollars: 10% of $25,000: $2,500
  2. Level 2 dollars: 15% of the next $25,000: $3,750
  3. Level 3 dollars: 20% of the remaining $5,000: $1000
  4. Total: $7,250
  5. Leaving you with: $47,750

So, the math is a little more complex, but this is definitely something you learned in high school. Why do we do this? Basically, it’s so you’ll never lose money by getting a raise. Go ahead and try it it out with whatever numbers you like, starting with more money will always leave you at step 5 with more money. If anyone ever tells you they don’t want a raise, because they’ll end up paying more taxes, point them to this.

Tax brackets are described for Income, Social Security, and Medicare taxes. Those are the 3 taxes that come out of your paycheck every week, if you work for a company (which is most of you). Your employer is also paying what are called Payroll taxes for you, basically doubling what you’re paying for Social Security and Medicare. If you happen to be self employed, you’re required to pay these yourself.

Part 3: Deductions and Credits

This is by far the largest part of the tax code, and can cause a lot of confusion. But, for most people, you’ll be able to ignore most of it. Part 3 is everything that counteracts part 1, basically telling us which of our income dollars are not going to be taxed.

First, what’s the difference between a deduction and a credit? They have similar results, but are different. a deduction is an expense (something you bought) that can be deducted from your total income. So, say you had to purchase a drum for $6,000 your new online drumming business, you can say “My income started from -$6,000, meaning I only made $49,000 dollars this year”. You can see how this shifts your tax burden.

A credit is taxes that the government says you already paid just by doing what you’ve done. This is different from a deduction in that it doesn’t change where the dollars are in the tax bracket, it instead essentially pays part of your burden.

There are deductions for all sorts of things, but most don’t matter to normal people; deductions and credits are how the federal government incentivizes people and businesses to do certain things and move into different markets. That sounds a bit nefarious, but it really isn’t. The government wants people to buy houses, so they give you a deduction for that. They want you people to move towards using solar energy, so you get credits for installing them.

The main deductions and credits you need to worry about if you’re reading this are home buyers credits, child tax credits, student loan interest deductions, and business expenses. The first 3 are really straight forward, they are straight numbers or percentages of what you bought. The forms will tell you what to do. Business expenses are a little more tricky, because they depend on subjective interpretations of what is needed for your business to run. These are the sorts of things that can get you into trouble with the IRS, so my honest opinion is, if it’s an honest business expense, you should absolutely deduct it, but trying to write off the new speakers you bought for your office is probably not something you want to try.

The Forms

A lot of different letters and numbers get thrown around, and that can be a bit confusing. Here’s what the most common ones mean:

  • W-4: This is a form you fill out when you first start working for an employer. It tells them how much money to deduct from your paycheck for taxes.
  • W-2: This is the form that the company sends you every year to tell you how much they paid in taxes for you. It is supposed to be in the mail (or delivered electronically) by January 31st. If you don’t receive this by the first week of February, your company can be in some tax trouble.
  • 1040EZ: This is what you fill out if you have no deductions and credits (besides the Earned Income Tax Credit). It is very quick and easy.
  • 1040A: If you don’t plan to itemize deductions. You claim credits, but not deductions
  • 1040: The full form
  • 1099: This is a form sent to you by a company who is claiming you as an income deduction, but did not pay taxes for you. Basically, if you were an independent contractor, a company will send you one of these if you cost over 600 dollars. You use this to report your income.

Are You Self Employed? 

When you work for a company, so long as you filled out your W-4 correctly, they will pay your taxes quarterly. If you’re self employed, you are required to do this, or else face penalty at the end of the year. You can read more about this here.

Use some software

So, you can do this all manually, and it’s really just some addition and subtraction, albeit a bit tedious. But the online software products really have made the whole thing take less than 20 minutes. TurboTax is the big name, but I’ve heard TaxAct and CreditKarma also have very good products. I’ve been using for TurboTax for years, and I’ve never had an issue.

 

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