Taxes 101, (a simple explanation of a complex system)

It is that time a year again, tax time is upon us. There are hundreds of strategies and approaches people deploy. Some people like getting a big refund as a kind of savings bonus, others want to break even because they do not want the government borrowing their money all year long. Remember it could have been invested for you all year making you money. I want to lay out a very simple way that one can think about taxes to develop an effective strategy. This is a taxes 101 that I wish someone had taught me a long time ago. Again, our education system never talks about this stuff and it is so important to us personally and for our country. It is important to pay our fair share and no more. Someone has to pay for defense, roads, food inspection, research, bio-defense, infrastructure, social security, etc.

In general, there are various tax brackets that you fall into depending on your income level. In general, the more money one makes, the more they pay in taxes as a percentage of income. Some call this a progressive tax structure, but that is not the point of this article. Even though one may make a certain amount that puts them in a specific bracket, you will want to deploy strategies to have deductions so it appears you are in a lower bracket. This way you pay less in taxes. Here are the brackets in general:

15% rate …….. $9,325 to $37,950

25% rate ……. $37,950 to $91,900

28% rate ……. $91,900 to $191,650

I am not going to list the others because the vast majority of tax payers fall into these brackets. The trick from this point is to qualify for deductions, that from a tax calculation perspective lower your gross income on paper. What are the most popular deductions:

A. Mortgage interest

B. Real estate taxes

C. Charitable contributions

D. State and local taxes

These popular deductions reduce tax collection by about $1 Trillion each year. So let’s say you made $100k last year, but were able to use the deductions above to look like you made $90k; Boom, you just lowered from the 28% tax rate down to 25%!

As a saver and investor, a huge way to take advantage of this system is to pay into an Individual Retirement Account. That money is also pulled off your gross income in terms of taxes. Just remember a Roth IRA is taxed now  in order to gain that back tax free as income in retirement. I try to increase these IRA investments to lower my tax burden now and later.

The next category of deductions are called tax credits. This is an amount of money taken directly off what you owe. Here are the most popular tax credits one should look into:

A. Earned income credit, depends on income level and number of children, usually for low to moderate incomes

B. Child and Dependent care credit

C. American opportunity credit, for certain education expenses

D. Lifetime learning credit

This is just meant as a taxes 101 explanation so that you understand the big picture structure. The tax code is thousands of pages long, therefore has become very complicated with many loopholes and provisions that individuals and corporations use to pay less in taxes. See a tax specialist with specific questions, this is meant as an overview and primer for how the system works. I am no tax expert, just trying to make sense of a complicated system and pay my fair share, but no more!

 

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