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Tax Time! The Simple Way (2019)

     Its tax time! Many people’s favorite time of year….some people, not so much. All depending on if you owe taxes or if you will receive a refund. Taxes may seem very confusing but it’s rather simple once you understand how it works. I will break down why you receive a refund, why you might owe taxes, how to prevent owing, and easy and cheap ways to file your 2018 tax returns. In the United States every state must pay a federal tax on any taxable income (I will discuss what is deemed taxable vs nontaxable). This means that depending on how much money you earned in your trade or business, you would be taxed at a certain percentage based on where you fall in the tax bracket. It is very important to understand how marginal taxes work and help clear up some common misconceptions. There may also be a state income tax depending on what state you live in but, let’s start with some common terminology:

     Gross income – Your paycheck BEFORE taxes are taken out is considered your gross income. The pay you see listed on job postings (the great postings that still list salary) are listed as gross salaries and would be considered your gross income.]

     Net income – Your paycheck AFTER taxes, deductions and expenses are taken out. These taxes include Federal income tax, state income tax, FICA taxes such as social security & Medicare. Other deductions may apply such as healthcare costs or pre-tax deductions but this can be really good to help lower your taxable income. For tax purposes we won’t focus much on net income.

     Taxable IncomeThis will be the number used to assess your tax liability or refund. This number is generally your gross income but you can lower it by taking certain deductions and exemptions. Why would you want to lower it? To receive a lower tax bill or greater refund!

     Deductions – These are items written into the tax code that allow you to deduct a certain portion of your taxable income and deem it as non-taxable. This is great news because although you will have made the same amount of money last year you will only be taxed on a lessor portion depending on if you meet the criteria. There are many deductions to take advantage of and all come with some sort of criteria that must be met. But, unless you have many assets and complex home interest rate tables that need the work of a CPA, most likely you will be taking the standard deduction. This is a deductions amount that is provided by the government and is different depending on your filing status (single, Married, head of household, etc.). Unless you have enough itemized deductions to offset the standard deduction it would not be worth it to itemize. Here are a few examples of key things that can be taken as an itemized deduction: Home mortgage interest, Medical expenses, charitable contributions, investment interest expense, property taxes and many others. Also many employers offer pre-tax investment options such as 403(b) Plans which allow you to deduct money from your gross income and put it into an investment fund to grow until retirement. Traditional IRA’s are similar in the fact that you can deduct part of the amount you contributed that year on your tax returns.

     Tax Credits – These are special tax refundable and nonrefundable credits that mostly help those have dependents and/or lower income tax payers, but many can apply to everyone. This is what generally generates a tax refund. These credits are applied AFTER your adjusted gross income (AGI) has already been determined and after the tax rate has already been applied. AGI is simply your Gross income minus all deductions and exemptions.

     How taxes work? Using the terminology above let’s look at a typical person working a 9-5. Single with a house and kid and see how their taxes play out:

     Mary is 35 with an 8 year old daughter. She does not live with the father of the child and they are not married. Mary would file as Head of Household because although she is single and not married, she has a child dependent that lives with her. Therefore she qualifies as head of a household. Now, let’s say Mary earns $71,000 as a nurse, contributes money to an IRA retirement account, bought an electric car that year and pays for daycare since she must work late. Her AGI would look something like this: (please note: This is just a brief example and does not take into account certain limitations if Mary itemized. Turbotax is a wonderful program and will crunch the numbers for you. All you will have to do is answer the questions. In this case the standard deduction would be the best case.

Gross Income

$71,000

Standard deduction

-$18,000

AGI

$53,000

Since Mary’s status is Head of Household she can deduct $18,000 of gross income. Bringing the taxable income down to $53,000. In prior years an exemptions could be claimed but that has been substituted with a higher standard deduction than in prior years. Now that we have our number let’s go ahead and assess the tax liability based on IRS guidelines:

Head of Household

If taxable income is over—

but not over—

the tax is:

$0

$13,600

10% of the amount over $0

$13,600

$51,800

$1,360 plus 12% of the amount over $13,600

$51,800

$82,500

$5,944 plus 22% of the amount over $51,800

$82,500

$157,500

$12,698 plus 24% of the amount over $82,500

$157,500

$200,000

$30,698 plus 32% of the amount over $157,500

$200,000

$500,000

$44,298 plus 35% of the amount over $200,000

$500,000

no limit

$149,298 plus 37% of the amount over $500,000

Mary’s AGI falls between $51,800 & $82,500. Therefore her tax would be:

HOH Tax Amount

$5,944

($1,200 x 22%)

$264

Tax assessed

$6,208

     Mary’s assessed tax bill would be $6,208. $5,944 just because her income fell between $13,600 & $51,800. Any amount above $51,800 up until $82,500 would be taxed at 22%. In this case that would be $1,200 ($53,000 AGI - $51,800 bracket) taxed at 22% ($264). This is very important to understand. This is called marginal taxes. It’s a common misconception that you shouldn’t try to earn more money because you will get taxed more. You will only be taxed marginally and based upon information on the tables provided by the IRS every year. Although a small part of Mary’s income was taxed at 22% her effective tax rate is still just at 12% which is normal! Now let’s get to the credits to lower this bill. (Note: Credits are applied AFTER the bill is assessed)

     Since Mary has a child under the age of 9 (and therefore also under the age of 16) she can claim 2 different child related credits. The child tax credit and the child care credit. Mary has also paid the max amount into her retirement investments and purchased a brand new Eco-Friendly car with a decent sized battery. So she can claim a few credits for that as well. She can also claim a credit for her child’s expenses so that she is able to work. Here is how her final assessment will look:

Tax Assessed

$6,208

Child Tax Credit

-$2,000.00

Child Care

-$600.00

Eco-Car

-$4,500.00

Tax Bill

($892)

 

     The original tax bill was $6,208.00. After applying the refundable credits Mary will be getting a refund of $892. These are all estimates and the credits can be more or less depending on how they are phased out. The minimum credit for an Eco Friendly car purchased brand new is $2,500 for a brand new car with a 5 KWh battery and the maximum is $7,500. This credit can certainly be more based on the battery size and weight. For this example, assuming she has a 7Hwh battery, she will receive about a $4,500 Credit. This credit is then followed by a Child Tax Credit which is usually $2,000 per child. Important to Note that not all credits are fully refundable. The child tax credit reduces the tax bill by up to $2,000 but is only refundable up to $1,400. In this case we reduced the tax bill by $2,000. We then have a Child Care Credit for expenses such as daycare and afterschool programs that the parent needs for their child (or dependent) in order to be able to work. This credit amounts to 20-35% of qualifying child care expenses up to $3,000. The percentage gets lower as your AGI gets higher. This is known as Phasing out. Mary’s AGI is higher than the amount needed to get 35% so she can claim 20% maximum. Mary pays $5,000 a year in child care expenses, she can claim a $600 Credit ($3,000 max allowable x 20%). These credits have completely eliminated Mary’s Tax lability and provided her a decent return given her level of income. If Mary did not purchase an eco-friendly car and instead bought a regular standard vehicle she would have incurred a tax lability. I will discuss the 2 possible outcomes and what to do increase your refund.

 

     Refunds: There are 2 main reasons to receive a refund from the IRS. Either you paid too much in taxes, or you qualify for great refundable credits and have maximized your deductions. Even if you do not qualify for any refundable credits it is still a very good feeling to not owe any money at all. Paying too much in taxes is a lot more common than you think. I will explain why it generally happens. When you get a new job as a W2 employee, Taxes are automatically collected on your behalf, and you get to choose how much. When you start you will be given a form W4 in which you will list your exemptions. This is basically a form commanding the IRS on how much taxes to withhold from your paycheck each time. The more exemptions you claim the less tax will be taken out of your paycheck for Federal and state (if applicable) purposes. Most people enter “1” as a safe mid-point because this gives them the safety of knowing they are withholding just enough taxes and they also have enough money in each paycheck to handle their regular expenses. But, it is all based on preference. Some people are fine listing “0”, which withholds the full amount by default. This will result in a smaller weekly paycheck but will maximize your chances of receiving a larger refund. Many others will enter as many exemptions as possible in order to have the largest paycheck possible even if it means potentially owing taxes. A good reason for that would be someone who feels that they have better use or investment opportunities with the extra weekly income that would outweigh the tax lability in the following year. No method is right or wrong and with both methods the tax payer will be paying the same amount of tax, it all depends on when you want your money. People who aren’t great savers tend to prefer a larger refund all at once instead of small chunks in each paycheck. For those of you that are independent contractors it will be UP TP YOU to estimate and pay your taxes when due. This is because you do not get FICA taxes taken out automatically from an employer. TurboTax has many tools and plugins that will help those of you that fall into this boat. I will cover taxation for business owners in a later article.

     Tax Bill: Owing taxes can be a very daunting feeling. Especially if you do not have the funds readily available. If it turns out that you do owe taxes it is very important to file your taxes on time either way. Filing late can accrue penalties and will make the bill even greater. The IRS is very understanding and offer payment plans for those that cannot fork out the entire tax bill at once, you just have to be upfront. This often happens to those that have borrowed from certain retirement funds but did not have the ability to pay it back, which results in an increase in income that wasn’t initially taxed. It is also common amongst 1099 (independent contractors) who don’t set aside enough taxes for their potential tax lability. Before a payment plan is even considered you can even file a 120 day extension to try and gather the funds for the tax liability. I will discuss a few simple ways to make sure you don’t owe. First, contribute to IRA and other retirement accounts. This will allow you to lower your AGI and qualify for more tax credits and you will be saving for retirement at the same time! There are limits to how much you can contribute each year for this very reason but maxing this out is a great way to plan for your future and lower your tax bill at the same time. Second, lower your withholdings. Sure, your paycheck may suffer a small decrease but if gives you a peace of mind to know that you won’t owe any money. For independent contractors, make sure to set money aside for your potential tax liabilities. There are various tax estimators you can use. Lastly, make sure you are maximizing all other deductions and credits, if you are ever in doubt you can always consult a CPA. Sometimes the cost of a professional looking over your work is absolutely worth it. Just make sure you research the individual or firm first.

 

     Final thoughts: This was just a way for you to understand how tax is computed on a very general level. If you can understand this you will truly understand what TurboTax is doing once you begin to use the software. You will understand the order in which things are done and why certain questions will be asked. Remember, every credit and deduction has stipulations, so if they ask a question that seems trivial or nonsensical it is just to see if you qualify based on a certain set of stipulations. Most people have a simple enough return that you will just need to enter your W2 and be done in 20 minutes. Head on over to Turbox.com and get started. Good luck!