Most individuals think about their taxes in the complete wrong way. I blame mainly the government and the payroll system. Instead, most of us have been trained to think of taxes as that one payment or refund check we get once a year before or on April 15th. Nothing could be further from the truth. Income taxes are the all year around bill that you pay and never even realize it. Instead, I give you the five things you must know about your income taxes.
1. Nearly everyone who draws a paycheck or gets a W-2 pays estimated income tax. Even if you don’t think of yourself as a complicated filer who would need to pay estimated taxes, you do pay them. I remember when I first started working at Staples at the tender age of 15 with the illustrious title of “Sales Associate.” Oh the joy of getting that first paycheck which I had already calculated in my head! Then, I actually opened it and realized, this is a lot less than I thought.
The fact is that most of us have been conditioned to forget to look at the taxes being drawn out of our checks every two weeks. It’s inevitable and we can do precious little on our own to change that amount, or can we? In part, the amount drawn out of your paycheck is determined by how you filled out your W4. The W4 is not a sacred covenant between you, your employer, and the government. It’s merely a tool to estimate the amount you should be paying in estimated taxes.
Read it very carefully and fill it out according to your situation. I file a new one with my employer every year. I fill them out based upon what I think will be happening that year. For example, last January I changed my filing for the whole year because I knew I was having a child in March. Is your partner quitting work? Are getting a big raise? Are you taking a pay cut? Are you adding dependents to your household? Look at a W4 annually.
2. There are at least five major figures you want to know on your tax return. KNOW your AGI. Most people are at least somewhat vaguely familiar with Adjusted Gross Income. The IRS helpfully describes AGI has your Gross Income minus adjustments to income. Realistically, what it’s actually describing is more like your net income, total income minus some deductions they allow. However, this is the base level from which the government is going to decide how much you should pay in total taxes. You should understand how this number is arrived at and understand two basic concepts I address next: above the line deductions & below the line deductions.
3. KNOW your Deductions & Taxable Income. Deductions reduce your income by varying amounts per legislation. Sometimes those deductions are dollar for dollar up to a certain ceiling or do not take effect until a floor is reached. However, as mentioned above, all deductions are either above the line (above the calculation for AGI and thus reducing it) or below the line (below this calculation). Above the line deductions are better than below the line because of their overall impact on your tax liability. Fool.com has a great article on exactly why this is the case.
In either case, AGI less all your deductions allowed below the line typically is your taxable income. This is the amount upon which your income will be applied to a tax table to determine the percentage of your income that you will have to pay out as taxes. The IRS publishes the annual tax tables from which you can calculate your tax from this figure.
4. Tax Due, Tax Payments, Tax Credits. Your tax due is the total amount due to the government. You never stroke a check for this whole amount; nevertheless, this is what you are actually paying. If direct deposit were never invented and employees were given their whole paycheck in actual check format, I am certain there would be a revolt if we were forced once a year to write a check for the entire amount you typically find on this line. Back to my original premise, largely we have been conditioned to see our taxes as only the amount we have to pay or get back in April.
Your tax payments are the amounts you have paid in estimate taxes throughout the year based on your W4 in most cases. Tax credits are actual reductions to the amount of tax you owe. This is very different from a deduction. A credit dollar for dollar reduces the actual amount of tax liability, not income.
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