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:
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.
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:
- 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.
- 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.
- 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
- 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!