How do taxes work?

It’s everybody’s favorite time of year: tax time. For most of us, taxes are a huge mystery; all year we watch the government take out way more than seems fair, each paycheck we swear up and down that there must be a mistake. Then tax timeFile:US-InternalRevenueService-Seal.svg comes around and we pay a professional or use an online service and either end up owing money (booooo) or we get money back (yay). The whole thing is really a mystery, and most of us have little to no idea how it works. I’ll do my best to simplify it a bit. I’ll explain it from the ‘top to the bottom’. I’ll try to tailor it to the type of income and taxes that you as a young professional face.
Gross income is this is the total income you’ve earned throughout the year and comes in 3 flavors. The most typical is the ‘W-2’. This is income from an employer. The next income type is the ‘1099’. This is income that comes from being self employed. The final type of income is ‘previously unreported’ i.e. tips or other income that you don’t get an official form for. Technically you should report amounts over a couple hundred of dollars. Technically. Interest and any ‘capital gains’ or dividends from gains on stock or various other investments are included separately and are taxed a bit differently. The old rate was 15%, but now it’s more closely aligned to your ‘common income’ rate.
Subtracted from your gross income are various deductions. The ‘standard deduction’ for a single filer is about $6k. This means that before any taxes hit, they let you subtract $6k. Various other deductions exist for having kids and a couple of other things. Any payments for health insurance are allowed to be deducted, as are contributions to a 401(k) retirement plan. This is nice because you are getting those tax free. Charitable contributions are also allowed to be deducted, but unless you are giving away more than the $6k standard deduction, they won’t really count (it’s an either or situation). Probably the most pertinent deduction for young professionals is the interest that we pay on student loans, you can take those off your taxes (up to $2,500). Interest on mortgages can also be deducted.
Out of your paycheck comes several different types of taxes. While you technically have the option to defer paying all taxes until April, the government doesn’t particularly like it, and for good reason; can you imagine being hit with the bill for several thousand dollars? Most people would fail at that. Anyways, lets talk about the different types of income taxes:
Federal: for most of us, we’ll fall into either the 10 or 15% tax bracket. This means that after deductions, you owe that percentage to the federal government.
Medicare: Despite all the flack we give our government, the Medicare healthcare system isn’t all that bad. (I work as a healthcare consultant, so I’m somewhat qualified in my assessment). You pay into this for all of your working life and then at age 65 are qualified to receive this healthcare. Thankfully it’s only about 1.5% of your income.
Social Security: Please see my article ‘Wait…I need to be thinking about retirement?’ if you are planning to rely on this as your retirement. When you get old and retire, you do become eligible to receive social security from the government, currently a couple hundred dollars a month. Ask your grandparents, it’s not really enough to live off of. In theory a safety net for people. This tax sets you back 6.4%.
State tax: most states also have an income tax that they levy, and the rate will vary state to state. I live in Georgia and pay right at 6%. Some states (shout out to Tennessee and Florida!) have no income tax, but you will pay more in sales tax in those states.
All this is going on each paycheck, and the idea is that a fairly accurate estimation of your taxes are removed and so when it comes tax time and you settle up with the government, you hopefully won’t owe that much.
Hopefully that has been a broad overview of how taxes work. You’ll realize that at least in theory, 2 of the 4 types of income tax (Medicare and social security) will come back to you when you retire. Still, taxes aren’t much fun and nobody really likes them (except accountants that actually do taxes). I trust now that you’ve got a decent understanding, and that you aren’t totally in the dark.
Next post, we’ll go into a bit more detail about certain situations, discuss some strategies, and I’ll try to hit some common questions.

4 Responses

  1. Capital gains(usually stock returns) tax depends on when you buy and sell. If you buy and sell in the calendar year, you are penalized much more than if you can wait until the next year to sell it. If you buy and sell in same year this amount is added(or subtracted if you lost money) to your gross income and gets taxed at your tax brackets rate! If you can hold off on selling, you only pay tax on the return at the capital gains rate.

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