Taxes: Everything you need to know

Taxes are a fundamental part of every citizen's financial life, yet they can be complex and sometimes overwhelming. This guide covers everything you need to know about taxes from my personal experience of filing taxes, from the basics to filing requirements, to help you navigate the tax system with confidence.

What Are Taxes?

Taxes are mandatory contributions levied by the government on individuals, businesses, and other entities to fund public services and infrastructure, including education, healthcare, defense, and social services. Taxes are collected at various levels, including federal, state, and local, and come in different forms such as income taxes, property taxes, and sales taxes.

Types of Taxes

Understanding the different types of taxes is crucial:

Income Taxes: Used on wages, salaries, business income, and other earnings, income taxes are the most significant revenue source for the federal government. In the U.S., both the federal government and many state governments impose income taxes.
Property Taxes: These taxes are based on the value of owned property, including land and buildings. Property taxes are typically collected by local governments and are used to fund services like schools, police, and fire departments.
Sales Taxes: Sales taxes are imposed on the sale of goods and services. Collected at the point of sale, these taxes are generally managed by state and local governments and vary by jurisdiction.
Excise Taxes: Excise taxes are specific taxes on particular goods, such as gasoline, alcohol, and tobacco. These taxes are often used to discourage the consumption of certain products and to fund related government programs.
Payroll Taxes: Payroll taxes fund Social Security and Medicare. Employers and employees share the responsibility for these taxes, with a portion of an employee's wages being withheld for payment to the federal government.
Capital Gains Taxes: Taxes on the profit from the sale of an asset, such as stocks, bonds, or real estate, are known as capital gains taxes. These can be short-term (for assets held less than a year) or long-term (for assets held longer).

Taxable Income: What It Is and How It’s Calculated

Taxable income is the portion of your total income that is subject to taxation. It’s calculated by taking your gross income—total income from all sources—and subtracting allowable deductions, exemptions, and adjustments. Taxable income is the amount on which your tax liability is based.

Gross Income: This includes all income you receive in the form of money, goods, property, and services that are not exempt from tax. Gross income encompasses wages, salaries, tips, business income, interest, dividends, rental income, and other sources.
Adjustments to Income: Certain deductions, known as "above-the-line" deductions, can reduce your gross income, leading to Adjusted Gross Income (AGI). Examples include contributions to retirement accounts (like a traditional IRA), student loan interest, and health savings account (HSA) contributions.
Deductions: After calculating AGI, you can reduce your taxable income further by claiming either the standard deduction or itemized deductions. The standard deduction is a fixed amount that reduces the income you’re taxed on, while itemized deductions allow you to deduct specific expenses like mortgage interest, state taxes, and charitable contributions.
Exemptions: Although the personal exemption was suspended starting in 2018, it’s essential to note that previously, exemptions allowed taxpayers to reduce their taxable income for each dependent claimed.
Taxable Income: Once adjustments, deductions, and exemptions are applied, the remaining income is your taxable income. This figure is used to determine how much tax you owe.

Deductions vs. Credits

Understanding the difference between deductions and credits is key to minimizing your tax liability:

Deductions: Deductions reduce your taxable income, which in turn lowers the amount of tax you owe. Common deductions include the standard deduction, mortgage interest, state and local taxes, medical expenses, and charitable contributions. Itemizing deductions can sometimes lead to a lower tax bill if your deductible expenses exceed the standard deduction.
Credits: Tax credits reduce your tax bill directly, dollar for dollar. Credits are more valuable than deductions because they apply directly to the amount of tax you owe rather than reducing your taxable income. Examples include the Earned Income Tax Credit (EITC), Child Tax Credit, education credits, and energy efficiency credits.

Tax Forms: Choosing the Right One

Filing taxes requires the use of specific forms, and choosing the correct one is crucial:

Form 1040: The standard form used by U.S. taxpayers to file their individual income tax returns. It accommodates a wide range of income types, deductions, and credits.
Schedules for Form 1040: Depending on your financial situation, you may need to attach additional *schedules to Form 1040, such as:
- Schedule A: For itemized deductions.
- Schedule B: For interest and ordinary dividends from investments.
- Schedule C: For profit or loss from a business (sole proprietorship).
- Schedule D: For capital gains and losses.
- Schedule E: For supplemental income or loss (rental real estate, royalties, partnerships, etc.).
*Tax schedules are forms the IRS requires you to prepare in addition to your tax return when you have certain types of income or deductions.
Form 1099: A series of forms used to report various types of income other than wages, salaries, and tips. Examples include 1099-MISC for miscellaneous income and 1099-INT for interest income.

Tax Rates and Brackets

The U.S. federal income tax system is progressive, meaning tax rates increase as taxable income increases. The IRS sets tax brackets that correspond to different levels of income, with each bracket taxed at a different rate. For example, in 2024, the tax brackets range from 10% for the lowest income levels to 37% for the highest.

Understanding your tax bracket is crucial because it determines the rate at which your last dollar of income is taxed. However, not all income is taxed at the highest rate within your bracket; only the income within that bracket is subject to that rate. This means that only parts of your income will be taxed at the highest rate since other parts of your income may come from other sources that are in lower tax rates.

Filing Requirements and Deadlines

Most U.S. citizens and residents are required to file a tax return if their income exceeds a certain threshold, which varies depending on filing status (single, married filing jointly, head of household, etc.) and age. The IRS sets these thresholds annually, and they are typically adjusted for inflation.

Filing Deadline: The standard deadline to file your federal income tax return is April 15th. If this date falls on a weekend or holiday, the deadline is extended to the next business day.
Extensions: If you need more time to file, you can request an extension by filing Form 4868 by the April deadline. This grants you an additional six months to file your return (until October 15th), but it does not extend the time to pay any taxes owed.

Common Tax Filing Challenges

Several challenges can arise during tax filing, especially if you have multiple income sources, deductions, or credits:

Self-Employment: Self-employed individuals must pay both the employee and employer portions of Social Security and Medicare taxes, which can increase tax liability. They also need to estimate and pay quarterly taxes.
Investment Income: Reporting investment income, such as dividends, interest, and capital gains, can be complex, particularly if you have multiple accounts or have made numerous transactions during the year.
State and Local Taxes: In addition to federal taxes, you may need to file state and local tax returns, each with its own rules and rates. Understanding the specific requirements in your area is essential.

Tips for Managing Taxes Effectively

Start Early: Avoid the stress of last-minute filing by starting early. This allows you to gather necessary documents, seek professional help if needed, and avoid errors.
Stay Organized: Keep all tax-related documents organized throughout the year. This includes receipts for deductible expenses, income statements, and any IRS correspondence.
Consider Professional Help: If your tax situation is complex or you don't completely understand it yourself, consider hiring a tax professional or using tax preparation software. They can help identify deductions and credits you might miss and ensure your return is accurate.
Review Before Filing: Double-check your return before filing to ensure all information is correct. Errors can delay your refund or result in penalties if you owe taxes.

Conclusion

Taxes are a critical part of financial life, funding essential government services and programs. Understanding how taxes work, how to calculate taxable income, the difference between deductions and credits, and how to file correctly is crucial for managing your finances effectively. While the process can be complex, staying organized, starting early, and seeking help when needed can make tax season less daunting. Remember, paying taxes is not only a legal obligation but also a contribution to the community and the services we all benefit from.