Ultimate Budget Series: Part 3 – Income Taxes

Ultimate Budget Series: Part 3 – Income Taxes

Income Taxes

Welcome back to the Ultimate Budget Series. If you haven’t have a chance to check out the rest of the series, here’s what we’ve got so far:

  1. Introduction
  2. Income
  3. Tithing

I remember when I got my first job at Fred Meyer (a grocery store for those not on the West Coast), and I BEYOND EXCITED to earn $6.25 an hour. I was scheduled for about 20 hours per week to start, so I quickly did the math and figured out I’d be $125 richer every week. BALLIN! But when I got my first check, I about died. Not only did I have to pay union dues (the crap am I going to do with a union at 16?), but I also saw another 15% of my check disappear to things like “Social Security”, “Medicare”, and “Federal Taxes”…? I thought taxes were for old people?? Well, after chatting with my parents for a bit, I realized that I will NEVER get my full paycheck. NOOOOOOOOOOO!

Yes, we are going to talk about taxes, even though you vowed not to THINK about then until next April! Now, taxes is a pretty popular subject among those to make money, as every hour they work is usually worth at least 20% less than they were promised by their employer. It’s not their employers fault, they are just following the laws of the land. No, if you want to go on a passive aggressive tirade in the comments section about how you would rather eat a pound of dirt than have someone’s hands in your pocket, leeching off your hard work, then you can direct your delightful rage at none other than the U.S. government.

Anyways, I didn’t come here to get all political and start a petition for a flat tax rate or anything like that, I came here to talk about how to exist in our current tax structure. And since most aren’t exempt from paying their fair share, let’s break it down so that you can be better informed, and then can at least have educated dissent.

Category Description

Income taxes are a government mandated charge on a percentage of your income, whereas failure to pay is punishable by law. In the U.S., there are federal income taxes (everyone), and state, county and city income taxes (some people).

How Much You Should Budget?

There are a few ways to approach this. Each method will vary depending on your type of income, and whether you are and employee of a company, or self-employed. Let’s take a look at a few examples:

  1. Income as an employee of a company. When you are employed by a company, they are required to pay taxes on your behalf before sending you the remaining money as your “net” paycheck. These are called “payroll” taxes. They withhold FICA (Social Security and Medicare) and Federal Income Taxes. The FICA portion is always the same percentage (currently 7.65%), and the Federal portion withheld is based on what you tell your employer on your W-4 form (you know, the form where you tell them a number and your paycheck gets bigger or smaller, with “0” making it the smallest). The best way to withhold the correct amount is to use the IRS tool provided to figure out what to claim on your W-4. You can check it out here. You’ll need to know a bit of information, so go check it out and then go find what you need to pick the right number.
  2. Income as a self-employed individual. When you are self-employed, you get the great privilege of paying more taxes than as an employee. WOOHOO! This is because a company pays half of the FICA taxes for an employee, and the employee pays the other half. When you are the owner AND employee, you get to pay both. Currently, that means you will effectively be paying 7.65% more in taxes than if you were an employee of a company. The amount you should budget for this category really depends on your business, your income, and the amount of projected profit for the business. My rule of thumb is to save 25% of you income for taxes, and then find a great tax professional. After reviewing your books for one year, they should be able to help you withhold the correct amount year after year and keep you out of trouble with the big, bad I.R.S.
  3. Investment Income. Investment income is awesome, and you should be happy that you have some! But you also need to know how much you will be paying in taxes on this income. There is a simple rule to paying taxes on your investment income. Any investment you have held over 1 year is long term income, and you pay 15% in taxes (0% for those in the 10-15% tax bracket, and 20% for those who make over $400,000 annually). Any investment you have held for less than 1 year is short term income, and you pay your ordinary income tax rate. So, when you chat with your investment advisor, or look at your
  4. Other Income. There are various other types of income, such as gifts, inheritances, and gambling winnings, and they all have their own tax treatment. If you find yourself receiving any other income outside of your job and investments, definitely connect with a tax professional to help you pay the correct amount of tax to protect you from the I.R.S., who is like friggin’ JAWS. They will eat you alive!

Common Ways People Blow This Category

Lack of understand. And I don’t blame ‘em! The U.S. tax code is RIDICULOUS, with stack after stack of 1,000+ page regulations being added regularly. There is NO WAY anyone can know it all, especially the common working folk who just want to pay their fair share and stay out of trouble. The problem is, when someone doesn’t not have a basic understand of how taxes work, they tend to not withhold enough from their paycheck, or, when self-employed, they don’t pay any taxes and wonder what they owe at the end of the year. When you don’t withhold enough, and owe over $1,000, you could get penalized. Your best bet is to play with the withholding tool I linked to above, or work with your tax advisor to ensure you are paying enough during the year. My worst client appointments are those who are self-employed and don’t pay anything all year and hope they just owe as much as last year. Unfortunately, their income is up, they don’t have any leftover losses to deduct, and they owe a TON of money on their profit for the year. Putting together a good plan at the beginning of the year should ensure a smooth tax time, and if something major change, then phone your local tax professional for advice.

Best Ways To Reduce Income Taxes

I’ve written before that tax deductions are a bad investment. And I stand by that claim. But, I also think everyone should only pay what they rightfully owe in taxes, and that means taking advantage of every possible deduction and credit they qualify for. There are a TON of them, so again, I recommend connecting with a tax professional to see which ones you qualify for. Some common ones are the child tax credit, education credits (for college classes), student loan interest deduction, property tax deduction, mortgage interest deduction, charitable contributions, and medical expenses. And don’t forget if you ever have to pay a ransom for a family member, it’s 100% deductible.

Whatever Else I Feel Like Writing

They say there are two things you can always count on; death and taxes. So, as much as we would love to never have to pay taxes again, it just ain’t gunna happen! I hope I have been helpful in breaking down income taxes a bit into something that’s more palatable, and will help you make better decisions when dealing with income taxes. As a tax pro myself, I’m always going to advocate finding a competent professional to assist you with your tax needs, especially if you own and home or business (or both!), or have any major life events that involve money.

If you’re adventurous, you can always peruse the tax code yourself, and search through the publications for answers to your tax questions (just check out www.irs.gov). Heck, I do it all the time! Just remember that you’re dealing with the U.S. government and “their money”, and if you screw it up, they’ll come after you like a jack-hammer to your frontal lobe. So yea, there’s that.

Comments: I know thinking about taxes right now makes you want to gouge your eyes out, but how did it go last year? Is there anything you’d change about your taxes? Do you “do it yourself”, or have a professional takes care of the details? I’d love to hear from those who are self-employed as well. This is the beginnings of a very LONG series, so I would LOVE to hear some feedback on what you think, and how I can help more with this series. Thanks for reading!

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Comments

  1. We do it slightly different than most people I know. We have been living on my husband’s income regardless of whether I brought in any income or not. So we put him as single for his company withholding. The adjustments we do in my withholding. When I was earning a full paycheck I claimed married with 3 or 4 deductions to balance out eventhough we didn’t have any kids. I usually do not budget more than 50% of my paycheck for the first few pay periods. I have found it usually takes that much time to adjust the withholding to the correct amount.

    After I quit and moved to Self employment we left my husband’s withholding as the same and I do not pay quarterly estimated tax. As we file jointly so far we have been doing fine.
    Suba @ Wealth Informatics recently posted..Long distance moving on the cheap: Part I, Moving with USPS, UPS and FedExMy Profile

  2. Looking forward to this series! I can use any and all help when it comes to taxes, especially since I’m making the switch to being self-employed.
    Michelle recently posted..Keep Driving An Old Car or Buy A New OneMy Profile

  3. I used to pay someone to do my taxes but not any more. I don’t own a business but I’m sure if I did I’d have to get a professional. For the most part I found it extremely easy and saved us $$ in the budget because now we don’t have to pay anyone. I got back $216 which was fine as I didn’t want to be paying the gov’t any more than I needed to be. Cheers mate
    Canadian Budget Binder recently posted..Bust Our Budget-May 2013 Budget Update #5: Summer ExpensesMy Profile

  4. I have used a CPA forever! I can do my own taxes, bu choose not to. I owned businesses, income property and homes which made a tax return more than ordinary. For the token fee, I have an expert crunch the numbers and I can ask all the questions I want during the year for fee. Win/win!
    krantcents recently posted..Congratulations Class of 2013, Now What?My Profile

  5. Nice breakdown. Taxes are one area where you can really save a lot of money if you plan well. It’s one of the most overlooked areas of investing in terms of boosting returns. Many people pay far too much in taxes because of poor investment management, even when they think their returns are great.

    One quick point though. Aren’t short term capital gains taxed at your ordinary income tax rate, rather than at a flat 28%?
    Matt Becker recently posted..Lessons Learned From a Flat TireMy Profile

    • Lol, yup. Sorry, I was writing late and thinking of it as a case study for someone in the 28% bracket, buy obviously I didn’t put that on paper. FOH! Updated post for clarity. Thanks Matt!!

  6. I do my own taxes even though I have self-employment income from my blogs. Since I am employed as a Tax Expert during the tax season I should be able to do my own taxes. My strategy has always been to claim 0 at my job which usually results in enough withholding to cover most of my self-employment tax. I ended up having to pay a small penalty for 2012 though so I’m making quarterly payments this year.
    Andy Hough recently posted..Swagbucks Bonus Sign Up CodeMy Profile

  7. This is my first year of self-employment taxes and I am getting ready to hand over 4K (4K!!!!) to the man on June 15th. It hurts and it’s a completely different feeling than it is when it’s deducted from payroll. I was trying not to think about it….UNTIL you reminded me. Thanks.=)
    Holly@ClubThrifty recently posted..Strategery: How I Save Time and Money Working from HomeMy Profile

  8. Taxes truly are complex and confusing, but I don’t think a ton about them. In fact, there are really only three occasions that I look at them:

    1. To find the effective cost of debt, due to tax deductions
    2. To find the effective value of investments, due to whether they’re taxable or not
    3. To find the effective price of other stuff that may be deductible…like health insurance or transit to work
    Debt Blag recently posted..June 2013 goals, including turning impulse buying into impulse student loan paymentsMy Profile

  9. We are blessed in a way that our income is low enough that, combined with our kid deductions, interest deductions and charitable deductions, we never end up paying anything in. That being said, I’d be all on board with a flat tax rate.
    Laurie @thefrugalfarmer recently posted..Some Link Love and Some Farm WorkMy Profile

  10. I hate having to budget for taxes. But it’s a necessity. One tax reducer we did last year was getting a SEP IRA. I highly recommend it to reduce your self-employed tax burden.
    The College Investor recently posted..Fannie and Freddie Shareholders: Hedge Funds vs. GovernmentMy Profile

  11. First born on Income Taxes? Whew – I only owed the State an Arm and the Feds a Leg. Guess I got off easy?
    PK recently posted..Male-Female Parity: A Result of Changing Industry Balance?My Profile

  12. This post is coming at a good time for me. I’m doing some side hustle work and was debating whether I needed to do quarterly taxes. Last year I had close to a $1000 return (I hadn’t planned it that way, but changes in my income made it that way). Because I got back so much and nothing has changed in my finances at my day job, everything should be the same this year, so I’m thinking I’ll just monitor how much extra money I’m making and make sure that I start doing quarterly if I make enough income to owe more than $1000.
    KK @ Student Debt Survivor recently posted..Priceless Skills I Learned at The Job I HatedMy Profile

  13. another downside of being self-employed. I pretty much spend all March in lockdown mode trying to get everything organized for my accountant. And you have to be very disciplined to take out a certain percentage each paycheck!
    Budget and the Beach recently posted..Fighting off the Shopping TemptationMy Profile

  14. I hope the self employment tax doesn’t come as a shock to people. That’s always a killer.

    Good news though, for those high earning peeps. Once you get above a certain threshold, FICA drops off and then you totally would CHA-CHING! except for that little fact that you’re in a higher tax bracket AND might be subject to AMT.

    They just keep finding other ways into your wallet….
    AverageJoe recently posted..I Accidentally Shopped at J CrewMy Profile

  15. When I make any side income, I stick 25% into a tax fund and it comes into play when I do income taxes the following year. Most of the time we still get a refund, so that just adds to the ‘refund’ if you will.
    Money Beagle recently posted..Assign Tasks To One Person And One Person OnlyMy Profile

  16. I know nothing about taxes except that the government usually takes their money before I get mine. Now that I am self employed I need to really grasped how this thing works. Thanks for the information. I didn’t know you pay more taxes being self employed. That sucks.
    Thomas @ Your Daily Finance recently posted..Stats Update, Side Hustles, and Post ScheduleMy Profile

  17. Income tax is a topic that not enough people know about. It is definitely something that need to be taught in school. Too many people get in trouble with their taxes, especially if they do contract and freelance work.

  18. Property Tax Loans says:

    We all need to pay taxes. Otherwise, we just move to countries where it is not required which also has certain limitations to freedom. No, thank you. Slowly,we need to understand taxation and find ways to get the deductions allowable. Talking to an accountant will help.

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