Expected Time: 5 minutes
What You’ll Need:
📝 Money Journal and Pen
Why It’s Important
Getting a huge tax refund every year might seem great, but it actually means you’re overpaying the government throughout the year, when you could be using that money for investing, paying down debt, or anything else that’s important to you.
On the other hand, having a large tax bill isn’t fun. Understanding the basics can help you prepare for a smooth tax season - no surprises necessary!
The information below is meant for educational purposes only, and cannot be considered investment advice. Consult with tax professional for questions on your specific situation.
Read below to understand how taxes work, then follow the links to complete tax best practices.
How Taxes Work
We pay taxes on our income, on most of the purchases we make, and on property we own.
Taxes are collected by federal, state, and local governments
And are then distributed to fund certain programs, like social programs that support low income families and retirees, national programs that support our military and health initiatives, and state-funded programs like education and improving roadways. These are just a sample of the programs supported by our taxes.
Types of Taxes
Tax rates applied to our earnings include the following:
Federal Insurance Contributions Act (FICA) Tax
Income Tax includes Federal Income Tax and State Income Tax (if applicable in your state). Your income tax rate is subject to your tax bracket, in which rates between 10% and 37% apply to segments of your pay. You’ll estimate your tax bracket in a later exercise.
FICA Tax includes Social Security Tax and Medicare Tax. Combined, the FICA tax rate is up to 15.3% of earnings, including 12.4% for Social Security and 2.9% for Medicare. If you’re employed, your employer splits this tax bill with you (so you each pay 6.2%).
If you are self-employed, you are on the hook for the full amount (see for details). Social Security Tax only applies to the first $147,000 of earnings, so if you earn more than that, you’ll only pay up to that amount. Medicare Tax increases by 0.9% for individuals who earn above $200,000 and married couples filing jointly who earn above $250,000.
Your Individual Responsibility
As individuals, we are responsible for selecting our tax status, or how we file each year, and selecting how much we want to withhold from our paychecks.
We are also responsible for setting aside taxes or planning for taxes if we owe due to tax events, like investment earnings or the sale of a property. Sometimes taxes are automatically withheld, and sometimes they aren’t, so it’s important to pay attention to minimize surprises when you file.
Filing means annually reporting what you’ve paid in taxes throughout the year, to calculate what you still owe based on your prior year earning and tax events. This is done with Form 1040, formally called the U.S. Individual Income Tax Return.
If you have paid more taxes than the tax liability that is calculated during the filing, you’ll get a refund. If you didn’t pay enough, you’ll owe tax at the time of filing.
Your tax liability can be reduced in two ways:
1) Deductions reduce your taxable income. Examples include contributing to your 401k with pre-tax earnings that are taken right out of your paycheck, or interest paid on student loans. Both of these reduce the amount of earnings that taxes apply to.
2) Credits reduce the amount of tax you owe. While deductions reduce your taxable income, credits reduce the amount of taxes you owe. Popular credits include some education spending and child tax credit.
Complete the exercises below to keep up with tax best practices all year round.