The Dreaded Tax Season
Hey friends! So how is your 2021 going so far? Here in New Jersey we have gotten a lot more snow than usual. Every time I turn around my car is covered with snow. Thankfully, I am still working from home most of the time so I’m not hating it as much as I would any other year. I hate driving in the snow. Now I get to look out the window and just enjoy it.
But this time of year not only means snow and cold for us Nor’easterns, it also means tax season for everyone in the US. And most people hate doing their taxes for a few reasons: lack of understanding, disorganization and they don’t know if they will end up owing money. That’s why I created this blog, taxes for beginners. My husband and I have never owed money and yet we still wait longer than we should to do my taxes. We are almost a week into the tax season and if you have already done your taxes, you are my motivation.
First, let me get this out of the way: I am not a professional. I’m just a person who enjoys learning about things I don’t know and who wants to share these things with my friends here on my blog. Today we will be talking about basic things regarding FEDERAL taxes. But here is my disclaimer, the information I am giving you is for educational and informational purposes only. Like I said, I am not a professional, use this as a starting point. Do your own research and talk to your tax person to discuss your personal situation.
This is the first blog of two regarding Taxes for Beginners. I split up the blog into two so it’s easier to digest. Part two will be up in the next few days so make sure you visit my page in a few days so you don’t miss that blog. It will include tips that you need to know before you go do your taxes so you don’t want to miss it.
Ok so there is one last thing that we need to do to close the chapter on 2020, our taxes. The deadline for filing your federal taxes this year is April 15 and just in case anyone is confused, when you file your taxes this year it will be for your 2020 income.
Federal taxes get taken out of every paycheck. Take a look at your paycheck stub and under the section titled deductions you will see a line that says federal taxes; that’s how much federal taxes where taken out of your paycheck. Now take a look at your W2. On block 1 it says how much wages, or money you received from your employer for the year. Block 2 shows how much federal taxes were deducted from your paycheck for the year. By law all employers are required to have all W2 to employees by Jan 31st.
The amount of federal taxes that is taken from your paycheck is determined by what you filled out as a withholding allowance on your W-4 form. This is the form you filled out when you first got hired but you can change this from time to time.
Here’s a good rule of thumb: the more allowances you claim, the less federal income tax your employer will withhold from your paycheck, that means the bigger your take home pay BUT the less refund you will get during tax season. The fewer allowances you claim, the more federal income tax your employer will withhold from your paycheck and that means the smaller your take home pay BUT the bigger your refund during tax season.
Therefore, you can adjust your W4 to change to what you prefer. Do you want the bigger paycheck or the bigger refund? Just talk to your tax guy first before you make any changes.
I prefer to get the big refund during tax season. I take that money and pay down any credit card debt we have from Christmas or that ends up being our vacation money. I am more disciplined getting a big amount all at once and using it responsibly than getting a little bit more every paycheck. There’s a much better chance I’ll spend it mindlessly when it’s only a few hundred dollars instead of a few thousand dollars.
Who is Required to File Federal Taxes?
So who is required to file their federal taxes? My two oldest kids had their first job over the summer, doing landscaping at a local park. That got me wondering, do they need to file taxes?
The amount of income that you made last year will determine if you have to file federal taxes. Income is considered anything you received in the form of payment. It includes money from your job or jobs, your business or self-employment, retirement benefits and investments. Here’s some great news for you, those stimulus checks you got last year are not being counted as income so yay for that! Listen people we are talking about taxes here, we have to find the positive things anywhere we can find them right!
Here is a breakdown of how to figure out if you need to file federal taxes. Keep in mind that this information is only good for the 2020 tax season and the minimum gross income can change every year. I’m going to keep saying this: confirm any information that you get here with your tax guy. You can see the different filing categories on the left. Your filing category is mostly determined by your age, your marital status, and your income.
Most of them are pretty self-explanatory but there’s two points I want to make. First, married couples have the option to file jointly or separately on their federal income tax return but the IRS strongly encourages couples to file joint tax returns by giving several tax breaks to those who file together. Married couples who file jointly usually receive higher income thresholds and deductions—this means they can earn a larger amount of income and qualify for certain tax breaks.
There are a few exceptions; the most common one is if one person had many out of pocket medical expenses, filing separately might be more beneficial. The only way to know which option is best for you is to prepare your taxes both ways, married filing jointly and married filing separately.
The other point is about head of household. To file as head of household, you must pay for more than half of the household expenses, be considered unmarried for the tax year, and you must have a qualifying child or dependent.
From what I’ve been reading, it looks like my kids are not going to have to file a tax return since we claim them as dependents. You can see from the chart above that even if we didn’t claim them as dependents, they still wouldn’t need to file their taxes because they fall under the category single and they didn’t make over $12,400 last year. However, I’m still going to ask my tax guy because there are so many rules that I am not going to assume anything. Check with your tax person to determine what is the best filing status for you.
Lastly, let’s go over key tax terms. These are words that you will hear over and over again when you are talking about taxes and knowing the definition will help build your confidence. We are going to use Chandler and Monica, who have 2 kids and file married jointly as an example. Please remember that the key terms and examples I am using are basic. There are plenty of other credits, deductions, adjustments and exemptions that I don’t cover that you might be eligible for.
Gross and Net Income
I’m sure you have heard the words gross income and net income and if you are like me you are thinking wait which one is which? Here’s my trick for remembering the difference between the two. Gross income is the money you make before they take any taxes out. It’s “gross” because you will never really see all that money. Net income is what you actually bring home.
Most of us, unless you are an accountant, only really care about net income, how much money we actually get. But remember, you can change your withholdings on your W4 to see a change in your net income. For our example, Chandler and Monica’s gross income for 2020 was $85,000.
AGI – Adjusted Gross Income
AGI stands for adjusted gross income. To get your AGI or taxable income take all your incomes, from your jobs, dividends, retirement benefits, interests and capital gains and subtract any deductions, which we will talk about next.
If you hear this next term, just smile because its helping you pay less taxes.
Tax deductions are expenses the IRS allows you to subtract from your gross income. (Look at that, I am already using a term you just learned!!!). You can either do the standard deduction or the itemized deductions. One or the other, you can’t do both.
Most taxpayers take the standard deduction. In fact, it is estimated that in 2018, 90% of households took the standard deduction. A standard deduction is a fixed dollar amount that you can subtract from your gross income. The standard deduction is available to all filers and is determined by the taxpayer’s filing status. The chart below shows you the standard deduction for each filing status.
Chandler and Monica with a gross income of $85,000, married filing jointly can take the $24,800 standard deduction bringing their Adjusted Gross Income (and there’s another term you just learned!!) to $60,200. This is the amount that they will have to pay taxes on….well as of right now.
Itemized deductions are more time consuming and require you to bring proof for every single thing you are going to claim. This obviously requires you to keep receipts of all these expenses for the entire year. Take a look at the standard deduction chart again. Find your standard deduction amount based on your filing status. If you didn’t spend more than that amount in charitable contributions and out of pocket medical expenses, just take the standard deduction; save yourself time. You either have to have been really, really charitable or had a lot of out of pocket medical expenses to surpass your standardized deduction.
Tax brackets refer to a range of incomes subject to a certain income tax rate. Because we have tax brackets here in the U.S. it means we have a progressive tax system. This means that as a person’s income grows so will the amount of taxes that they pay. Low incomes fall into the lower tax rates and higher incomes fall into the higher rates.
This chart shows that for 2020, there are seven tax brackets.
The Bings, with their taxable income of $60,200 fall into the second tax bracket of 12%. You can see how important deductions are to help you pay less taxes. If there was no standard deduction, Chandler and Monica would fall into the third tax bracket of 22%. And here is even more good news: they aren’t going to have to pay 12% on the entire 60,200. They will pay 10% on the first $19,750 (first tax bracket) and then they will have to pay 12% on the other $40,450 (60,200-19,750).
1,9750 * .10= 1,975
40,450 * .12= 4,854
When we add up those two numbers: 1,975 and 4,854 the total they will owe in taxes is $6,829.
So we got the AGI for Chandler and Monica, but wait there’s more. Here is another term that should bring a smile to your face: tax credit. A tax credit is an amount of money that you can subtract directly from the taxes you owe to the government. Unlike deductions, which reduce the amount of taxable income, tax credits reduce the actual amount of tax owed. So if you have the option of a tax credit or a tax deduction, a tax credit will probably benefit you the most because they cut the amount of taxes you owe.
One tax credit out there for this tax season is the Earned Income Tax credit. If you made less than $56,844 you might qualify for it and it could save you, hundreds maybe even thousands of dollars. I found out that one out of five taxpayers doesn’t claim the Earned Income Tax Credit so make sure you ask your tax person if you qualify for it.
If you have kids, there is the Child Tax Credit. You can claim up to $2,000 per qualified child with this tax credit. Chandler and Monica have two kids they can claim for a total of $4,000. Because of this $4,000 tax credit, now the amount they owe in taxes is $2,829.
Remember, all the numbers and examples I used are basic examples. I don’t want no problems with you after you get your taxes done and things didn’t come out exactly like I explained in this blog.
Before you go do your taxes, do some research on what the criteria is for some of these credits. I’ve realized that a lot of tax people aren’t as educated as they should be and might be costing you money by not applying some tax credits or deductions that you qualify for. So if you go in and tell them you think you qualify for this and that, it will force them to look into it.
The Impact of the W4
Let’s go back to that W4 form really quickly. You might have ended up paying more taxes in 2020 every time they took federal taxes out of your paychecks so that’s why some people end up getting money back during tax season like we do. We pay more taxes throughout the year than we actually owe and that’s why we get a refund. Then there are people that didn’t pay enough and they end up having a tax bill. You can now see how what you put on that W4 will impact you every tax season.
Keep Educating Yourself
There were many tax terms in today’s blog but knowing them is important. You don’t need to be an expert on this but you want to have a basic understanding because taxes impact you where you feel it the most, in your pockets and taxes are something you will have to pay for the rest of your life. It’s only wise to get more educated in this area to see how you can pay the least amount of taxes legally.
In the next blog I will provide you with a checklist and tips from the pros to help you get through this tax season as painless as possible. Consider signing up for my newsletter, Money Moves….& More to stay up to date.
To Your Finances,