Money Mommy

Stuff your mom should have taught you, but didn't…

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Tag: Taxes

On Deductions and Taxes

People are so full of good advice – Especially when it comes to your taxes.

Do you want a new car?  “The sales tax on your new car is deductible.”

Feeling philanthropic? “Your donation is tax deductible.”

Need new doors or windows? “You can get a nice energy credit.”

Feeling bad about all those loosing lottery ticket? “My neighbor deducted all of his losing tickets.”

Student loans? “Big deal. The interest is tax deductible”

And so it goes with medical bills, mileage, home mortgages…so many things can reduce your taxes! You should spend! spend! spend!

It all sounds great.  Until you do your taxes, and you find that not much has changed.  So what happened to that awesome refund you were promised.

Lots of things.

Let’s look at the actual reason for doing your taxes every year.  Our United States tax is a “pay-as-you-go” system.  We are expected to pay our taxes on income as we earn it.  This is why our employer withholds taxes every pay day.  Individuals who are self-employed are expected to make estimated payments every quarter as well.  Then, by April of the following year, we look at all our income and determine how much we should have actually paid.  Did we pay too much? – We get a refund.  Did we pay too little? – We owe taxes.

Now, to complicate matters, the United States government offers incentives to encourage their citizens to act “responsibly.”  The government also reduces taxes to provide much needed relief in specific circumstances.

But let’s go back to that stack of deductions.

If you haven’t paid any taxes to the IRS, you won’t get a refund.  By the very definition of the word, refund, you are getting back what you have already paid in.  So, if you haven’t paid in any taxes you won’t get any money back.  Refund is money that you already paid in.

My sister-in-law plans to retire next year.  Due to the nuances of the tax system, she will not owe any taxes next year. She will not be required to file.  She will she not get a refund. In fact, she won’t have paid any taxes at all.  “But what about all my medical bills? Can’t I deduct them?,” she asked me.  The answer is yes and no.  Yes, you can keep track of all your deductions, fill out a tax form and send it off to the IRS.  But, no, you won’t get any refund since you never paid any taxes in the first place. In fact, your income is below the filing threshold so the IRS doesn’t even require that you fill out a tax return.  So what is the point of filing?

(Just to be clear, there are a few certain times that you can get money back that you hadn’t actually paid in, generally when there are children involved.  These are credits.  Some of them are refundable. We will discuss that in another post.  -MoneyMommy)

Perhaps you did have a job and you did pay taxes. Good for you! Currently, nearly every American citizen can reduce their gross income by over $10,000.00 to get to their taxable income.  If your taxable income is decreased to zero or below, you should not owe any taxes.  In fact you should get a full refund of your federal taxes that were withheld throughout the year.  More deductions will not cause you to get a bigger refund when you are already getting everything back.

The standard deduction is a gift to the American populace. Nearly every taxpayer can take the standard deduction, currently $6,200 for a single person, off their taxable income.   If all your deductions do not exceed the standard deduction, it is pointless to itemize your deductions. For instance, my neighbor has paid off his home.  His property taxes are just $525 and he donates $300 to his favorite charities, for total deductions of $825.  He can reduce his taxable income by $825 or he can use the delightful standard deduction and reduce his taxable income by $6,200. It’s a no-brainer.  He’ll reduce his income by the full $6,200, and save at least $620 on his taxes, if he’s in the ten percent tax bracket. AND he did not have to spend any of the $6,200 in the first place. Married couples can take double that amount ($12,400!) off their taxable income.  So, if your deductions are not even close to the standard deduction, all those papers that state “may be tax deductible” will not affect your refund at all.

But, beware! higher earners may run afoul of the dreaded AMT tax.  The AMT is a parallel tax system established in 1969.  The AMT tax is designed to ensure that everyone pays their fair share of taxes by eliminating many deductions. I’ll save that topic for another day.

To recap, deductions can certainly increase your refund by reducing your taxable income.  But it is certainly not a one-size-fits-all.  You need to examine your own circumstances to see what course of action is best for you.  When in doubt, talk to a tax professional.  And don’t rely on hearsay from your neighbor down the street.  Chances are, he’s about to be audited for deducting all those losing lottery tickets.

 

“What do you mean, I gotta pay taxes!!?” I’m a contractor!

Congratulations!  You are finally done with school and have entered the work place.

A REAL JOB.  With REAL MONEY.

And your nice boss has hired you on as a contract worker!

He says you won’t have any taxes taken out of your paycheck.

And you get to take lots and lots of deductions.

Things couldn’t be better…Until you sit down to do your taxes in early April….That’s when reality hits.

You can’t deduct a home office when you actually work somewhere else.  You can’t deduct your gas and mileage and tolls when you drive to work – that’s called commuting.  In fact, your nice boss provides you with your tools, office supplies, work station. Everything.  You actually don’t have any deductions at all.

It’s about this moment in the tax preparation process that people start moaning that they don’t pay for more work items out of their own pocket.  Don’t fall into this trap!  Remember, everytime you haven’t had to pay for anything, you kept more money in your own pocket.

But I digress.  Anyone who is a contract worker must save for the April 15th reckoning with the tax man.  The contract worker pays his own federal tax, social security tax, medicare tax, state tax, and any additional tax imposed by his locality.  These are all the taxes that an employer would generally have withheld from his employee’s paycheck.  In addition, the contract worker will also pay the employer’s share of the social security tax and medicare tax.

So, as a rule of thumb, the contract worker should save a minimum of 35% of every pay check they receive:

  • 10% – 25% Federal Tax
  • 6.2% Social Security
  • 1.45% Medicare Tax
  • 5% – 7% State and Local Taxes
  • 6.2% Employer portion of Social Security Tax
  • 1.45% Employer portion of Medicare Tax
  • 30.3% – 47.3% Total taxes to save

Well, looking at the above taxes, perhaps the higher earning contract worker should aim to save closer to 50% of their check.

Both my daughter and daughter-in-law were hired as contract workers before they were actually permanently hired as employees at their respective firms.  I can still hear my daughter wailing, “You mean I have to pay taxes on all that money!?”  Well, sure.  So does the rest of the country.

Open a seperate account in your bank, and label it your tax account.  Put 35% – 50% of every paycheck you receive into it.  Without fail.  If you doubt this amount, recheck my numbers above, or find a friend or family member who is working and will let you look at their paystub; take a look at the taxes that are withheld.  You will see that taxes have reduced their check by nearly one quarter to one third.  And don’t forget you will need to double the social security tax and the medicare tax, since your nice boss is not paying for that.  You will need to save at least one third of your earnings.

Mark down how much is in your tax account on December 31.  Now figure out your taxes.  Do you have enough in your tax account as of December 31 to pay the taxes?  Good for you!  If not, you will want to increase the amount of each check that you save.  Anything extra is yours to do as you want.

And my daughter and my daughter-in-law?  They both saved 35% of their checks.  My daughter-in-law  had just enough to pay her taxes on April 15 and was delighted it had worked so well.  My daughter, who earned much less and had a much lower federal tax rate, had enough left in her tax account as of December 31 to take a once in a life time trip to Jamaica. She ziplined through the tropical forest that spring.