Tax day falls in the middle of Financial Literacy Month. It’s a good opportunity for us to cover the basics of taxes and instill some financial literacy education while the subject is fresh on everyone’s mind.
Kinds of Taxes
- Income Taxes are collected from people who draw an income in the US. The income taxed includes wages & salaries from employment, tips, dividends and capital gains from investments, disbursements from traditional IRAs, alimony payments and unemployment checks. And if one’s income reaches a certain level, Social Security benefits are taxed as well.
- Payroll Taxes are withheld from workers’ paychecks by their employers and paid directly to the government. The biggest payroll tax is FICA (Federal insurance Contributions Act), which goes to fund Social Security and Medicare. There are also state and federal unemployment taxes paid by employers.
- Sales Taxes are collect at the point of purchase of goods and services. These taxes are paid by the end user, so a retailer doesn’t pay tax on wholesale purchases from a manufacturer. Since sales taxes may be applied at the Federal, state, and local levels, there may be multiple taxes applied on a given purchase. Some online retailers who sell to people in other states will not charge extra sales taxes.
- Property Taxes are collected from homeowners based on the assessed value of the property, and are primarily assessed at a local level, rather than federally. There are also annual property taxes levied on vehicle owners in most locations. These taxes typically fund local roads and services like fire, police and emergency response.
The bulk of taxes collected in the US are taken through income tax withholding. Hired workers pay out of every check throughout the year, instead of paying their tax burden in one lump sum at the end of the year. Earners may also elect to not have taxes withheld, and opt to pay in a lump sum instead. Filing tax returns every year, taxpayers must establish that they paid enough, or if they overpaid, claim a refund. The IRS issues refund checks after tax returns are filed.
Reducing Taxable Income
Taxpayers may reduce their taxable income in various ways:
- Contribute to a retirement fund—contributions to qualifying retirement funds can be exempted from your annual income, lowering the total amount you are taxed upon. You will have to pay taxes on the retirement income some day when the funds are withdrawn.
- Charitable contributions—the amount contributing to a charity may be deducted from your total taxable income. For sizeable donations, taxpayers need to get paperwork from the charity acknowledging the donation’s value.
- Losses—if you have taxable investment accounts, you may deduct the amount lost from your taxable income. This can apply to property as well; if you sell an investment property for less than you paid for it, you can deduct the loss. This does not apply to personal property you use, though.
- Carry-forward deductions—some deductions may be “carried over” from one year to the next. Your deductible charitable contributions are capped at 50% of your income, but if you donate more than 50% of your income, you may be able to carry the remaining amount over to the following year. Some capital losses, retirement contributions, and other business expenses may be carried over to subsequent years as well.
- Mortgage interest deduction—interest paid on a primary mortgage loan is deductible from a taxpayer’s adjusted gross income.
Standard vs. Itemized Deductions
The IRS allows a standard deduction for certain taxpayers, that is an amount set by law, or varying based on the individual’s circumstances. Itemized deductions include calculating some of the categories listed below, like charitable contributions, plus expenses like medical and education expenses, as well as business expenses. One can only take the standard deduction or itemize; the two categories of deductions cannot be mixed.
Tax credits are distinguished from deductions. Deductions reduce the total taxable income before taxes are calculated. Tax credits are subtracted from your total tax bill. Credits are typically preferable to deductions, even if the dollar amount of the deduction is higher than the tax credit.
For example, the median US income is around $42,000, a wage that carries a 25% tax rate. At 25% you might expect to pay $10,500 in taxes*. If you were given a $4,000 deduction, your taxable income would only be $38,000, so your 25% would total $9,500 or $1,000 less. So in this example a tax credit of $1,000 would be equivalent to a $4,000 tax deduction.
*It’s important to note here that this math is wrong! 25% is the marginal tax rate for a single earner at $42,000. What do we mean by marginal? Read on…
Income tax brackets
US federal income tax is progressive. That means the tax rates go up at certain income levels. So currently, earners below $9,275 in taxable income pay 10% in taxes. From $9,276 to $37,650, one pays 15% in taxes. From $37,650 to $91,150, the tax rate is 25%. From $91,150 to $190,150, the rate is 28%. From $190,150 $413,350 the rate is 33%. From $413,350 to $415,050, the rate is 35%, and over $415,050, the rate is 39.6%. The taxes change for each set of dollars, so if you earn $10,000 in taxable income, you pay 10% on the first $9,276 in income, and you only pay the 15% rate on the last $724 of income. Even though you’re only paying 15% on a small portion of your income, 15% is your marginal rate.
All of these numbers are for Federal taxes; state tax rates vary, and some states have no personal income taxes at all.
If you overpaid during the year, you can expect a refund check or direct deposit. If you file your taxes electronically, you can get a refund relatively quickly—10 days or less. Our standard advice is to adjust your withholding and plan to get a very small refund. It’s never good to owe more money when tax time comes, and if you overpay too much, you’re depriving yourself of income during the course of the year.
We want more people to use their refunds responsibly—pay down debt or use the money to establish an emergency savings fund. Too many people treat refunds like lottery winnings to be splurged with, but that is money you worked for all year, and it should be treated like every other dollar.
The government’s rationale for taxes to pay for the operation of the country—defense, infrastructure, etc. Some taxes, however, are designed to influence behavior. We talked in our post on Supply & Demand how taxes can be used to reduce demand for unwanted behavior, like using cigarette taxes to discourage smoking. And tax deductions like the mortgage interest deduction are offered to encourage positive behavior (homeownership, in this case).
It’s a popular idea to introduce “sin” taxes on undesirable behavior, because there is little downside for politicians who propose them. A city may introduce a tax on sugary soft drinks to help make people healthier. Since making everyone healthier seems like a noble goal, the government is able to raise taxes without upsetting people too much.
So-called sin taxes do have downsides. As we’ve discussed before, raising the cost of certain activities reduces demand for them, but if the government has grown used to the revenues from those taxes, it will face budget deficits.
Another problem is sin taxes tend to disproportionately burden the poor. Taxes on activities like gambling and smoking impact the poor because they are more likely to gamble and smoke.
Another thing to consider is that sin taxes are an acknowledgment of a basic economic principle: if you tax something, you’ll get less of it. So if taxing cigarettes gets us fewer smokers, do property taxes discourage property ownership? Remember that while there is broad agreement that taxes do influence behavior in this way, the effect may vary greatly in magnitude.
We talked about externalities in our post about the Basics of Trade. An externality is a cost or benefit to 3rd parties in a transaction. The concept was introduced by economist Arthur Pigou, which is where the term “Pigovian” comes from.
A Pigovian tax might be a tax on environmental pollution caused by a factory. The factory sells its product to willing buyers, but the people who live nearby bear the cost of the pollution. So the factory’s activity might be taxed to compensate for the damage they are doing, and to influence them to output less pollution. Another example of a negative externality might be traffic congestion. A city might impose a Pigovian tax on vehicles or gasoline. This tax might help pay for roads, and also discourage unnecessary driving and ease the traffic congestion.
Taxes and Bankruptcy
If you owe back taxes to the IRS, the consequences can be severe—tax evasion can land you in prison. Simply put, it is almost impossible to get out of paying your taxes.
In some limited circumstances, a tax debt might be wiped out when you file Chapter 7 bankruptcy.
If bankruptcy seems like your only option, you can call us for bankruptcy counseling and education, but we do not provide legal advice, so we urge anyone considering bankruptcy to seek the services of a qualified attorney.
In many cases, failure to pay taxes will result in a tax lien being placed on property. That means the IRS has a legal claim on your property until you pay what you owe. A lien shows up on your credit report and will affect your ability to get loans or credit. It will make it difficult to sell or lease property, since the IRS typically has the priority claim on property they place a lien on.
The only true way to get out of a lien is to pay, though there are circumstances where the IRS may ‘withdraw’ the lien. If they do this, you still owe them and you are expected to pay. They might do this to make it possible for you to sell property, thereby giving you an opportunity to make the money needed to pay them.
A tax levy is different from a lien in that your property is actually taken, or “levied” by the IRS. That includes garnishing wages or taking your property and selling it to satisfy your debt.
We’ve barely scratched the surface here; taxation is a very large subject! Tax law is complex and the IRS should be taken seriously. We suggest being very careful in any kind of negotiation to repay or settle outstanding taxes due.