Tax season is here again, and the deadline to file your taxes this year is Monday, April 18. As this deadline is fast approaching, we want to ensure you have everything you need to make tax season as painless as possible. Please note that FLIT Invest is not a tax advisor, and this article should not be considered tax advice. If you need any additional guidance, please contact a tax advisor.
We’re all too familiar with paying taxes, as significant amounts of money get deducted from our paychecks. However, there is little understanding of how taxes are used and calculated and how to optimize them. This is due to the complex tax laws, the time it takes to read and understand all the details, and the lack of education around the topic.
We’ll summarize the most critical aspects of taxes, why we pay them, how they are calculated and how to file them.
What is income tax?
Income tax is imposed on all income types, including salaries, business income, cryptocurrency, dividends, etc. Everyone needs to pay it, including individuals, corporations, and trusts.
Tax year and the deadline to file
The tax year is the year you calculate and submit your taxes and is usually the same as the calendar year, starting on January 1 and ending on December 31. You can change your tax year (for example, to begin on April 1 and end on March 31), but it’s not something most individuals opt-in for.
If you file your taxes for the calendar year, the deadline for filing is generally April 15 of every year. Estimated tax payments are paid quarterly for people whose tax isn’t automatically deducted from their paychecks. They mainly include self-employment income, interest, dividends, alimony, or rental income. State income tax filing and payment deadlines can differ from the federal deadline. You can check the deadlines with your respective state tax agencies.
Federal income tax vs. state income tax
The U.S. has a multi-level income tax system. This means that taxes are imposed at the federal, state, and local government levels. Federal and state tax systems can differ from each other in terms of tax rates, taxable income definition, and tax credits.
Everyone with earned income needs to pay federal income taxes, where the same rules and rates apply. On top of the federal income tax, you also need to pay state income taxes in most states. Finally, you may also need to pay income tax at the local government level on top of federal and state income taxes.
The federal income tax is a progressive tax system which means people with higher income pay more tax at higher rates. State tax systems vary but are generally progressive (e.g., Connecticut, Mississippi) or flat -meaning everyone pays the same tax rate (e.g., Colorado and Utah). Some states like Texas or Florida do not impose an income tax.
How to read your paycheck and how that ties to your year-end taxes
Most individual income taxes are paid throughout the year as they get deducted from wages, called income tax withholding. Employers transfer the tax directly to the government, while employees only receive the net (after-tax) amount. Besides income tax, Social Security and Medicare taxes are also withheld from paychecks.
Employers calculate the amount withheld for federal income taxes based on the IRS Form W-4. This form needs to be filled out by employees providing their personal information. Questions mainly include the number of jobs held, marital status, number of children, and other income. You must fill out this form as accurately as possible. If less than 90% of your total income taxes are withheld at the end of the year, you will be subject to penalties. State income taxes are often also determined using the same form. Still, some states use their own forms to calculate the amount of state income tax withholding.
The IRS Form W-4 won’t show you how much of your salary will be withheld, but it’s worth calculating for your own benefit. The easiest way is to use the calculator provided by the IRS. If you would pay less than 90% of the tax you need to pay, you can always submit a new form to your employer to adjust the tax withheld from your salary. When you need to file your taxes in April, you will look back to the entire year and calculate how much in total you need to pay as income tax. Suppose the calculated amount is higher than what was already deducted from your paycheck. In that case, you must pay the difference by the deadline. If you paid more than necessary, you would be eligible for a refund.
What is your taxable income?
Your taxable income is your total income minus all the deductions. Total income includes your earned income for the year, including wages, tips, interest, dividends, rental income, and any other sources of income.
Capital gains and qualified dividends are also part of your taxable income. However, they are taxed at a lower rate. Capital gains are your profits from selling stocks, bonds, crypto, and other assets.
Tax credits and deductions
- Tax credit: Tax credits get deducted from the amount of tax you owe.
- Non-refundable tax credits only decrease your total tax due.
- Refundable credits get refunded even if they are higher than your total taxes.
- Tax deduction: Tax deductions decrease your taxable income; therefore, your taxes will be calculated based on a lower income.
Tax credits may be claimed for several reasons. The main categories include family and dependent credits, income and savings credits, homeowner credits, healthcare credits, and education credits.
For example, suppose you pay someone to care for your dependent younger than 13 or for a spouse or dependent who cannot care for themselves. In that case, you may qualify for a family and dependent credit and reduce the amount of taxes that you owe by the credit.
There are two ways to claim tax deductions- standard or itemized. You must consider which option is the best for you. Standard deduction means you can reduce your taxable income by a pre-defined standard amount, which is $12,550 for single taxpayers and $25,100 for married couples filing jointly in 2021. Alternatively, you can claim tax deductions item by item. This second option is only worth doing if you are confident that you can claim more than the standard amount.
Tax deduction categories include work-related deductions (home office, etc.), itemized deductions (tax, charitable contributions, interest expense, etc.), education deductions (student loan interest, etc.), healthcare deductions (medical expenses, health savings account), and investment-related deductions (sale of a home, etc.).
You can find the complete list of tax credits and deductions and check your eligibility on the IRS website.
How to optimize your taxes
There are several ways to optimize your taxes. Unfortunately, most of the options are for self-employed people. However, there are still some ways to reduce your taxes as an employee.
The first and easiest is to open and fund a traditional individual retirement account (IRA). It is a “pay taxes later” strategy. Contributions made to your IRA are pre-tax, meaning you won’t pay taxes on this part of your salary. You will only need to pay taxes once you make a withdrawal from the account during your retirement. If you didn’t contribute anything last year but want to contribute for 2021, you still have a chance to do so before April 18. You will deduct the amount you contribute from your taxable income, reducing your federal income tax. The annual IRA contribution limit is $6,000 in 2021 and 2022 ($7,000 if age 50 or older).
Another good option is to keep track of your charitable donations. If you decide to opt-in for itemized tax deductions, you can deduct all donations made to charity. This is true, even if it was deducted from your paycheck, donated in cash or check, or even if you donated goods.
How to file your taxes
Federal income tax filing is available electronically and in paper form that needs to be posted to the IRS (separate addresses for each state). However, the IRS prefers to receive the forms electronically and warns people that it can take 6 to 8 weeks to process the tax returns if you file them in paper form.
To file the federal tax form electronically, the IRS offers Free File software for anyone with an income below $72,000 (in some cases, with free state tax filing). There is also a free electronic form for individuals with an income above $72,000 but with limited guidance and no state filing option. Both solutions are available on the IRS website. Alternatively, there are plenty of online solutions to choose from, and there are also professional services focused on tax filing.
Bonus: Why do we pay taxes, and how are they spent?
The U.S. government’s primary income source is tax payments. As reported by the U.S. Treasury, 41% of their total income was from Individual income taxes and 25% from Social Insurance and Retirement Contributions in 2021. As a comparison, only 5% of their income was from corporate income taxes. This means the U.S. government is mainly financed through individual taxes and wouldn’t be able to maintain most public services and benefits without individual tax contributions. This income essentially (but not entirely) covers what the government needs to spend to run the country.
Part of this income is spent on Income Security (24% of all spending in 2020) – mainly unemployment, housing assistance, and other income security benefits. The government spends almost this much on Social Security (17%), primarily retirement and disability benefits. The third-largest category is Healthcare (12%), closely followed by National Defense (11%) and Medicare (10%).
Overall, the federal income (around $4.05 trillion) doesn’t cover all the spending (around $6.82 trillion), which means a large part of the expenses must be covered by debt.
Please note that FLIT Invest is not a tax advisor, and this article should not be considered tax advice. Before implementing any transactions and/or strategies, you should consult tax, legal, and accounting advisors.