Don’t give the government free loans through your taxes | Few Minute Finance

Welcome to Taxes 101.

Luke Miller, "Few Minute Finance"

Taxes – ‘tis the season. The IRS began accepting tax returns on Feb. 12, and many Americans have already filed their taxes since or soon will. Many of them will be getting a tax refund. Referencing numbers from IRS filing statistics for the 2019 tax year, Ramsey Solutions points out about 111 million Americans got tax refunds, the average being $2,860 returned.

Tax details can get complicated quickly, driving a vast number of people to outsource the task to professionals, and tax rules change year to year. I am not a tax professional, but I have dealt with taxes and their implications firsthand for years. My aim is to make the topic less “mystical”, giving you a top-down view with helpful steps to making life easier.

In the United States, you owe and pay taxes as you earn income throughout the year. Depending on the amount and filing status (single, married, etc.), your income is taxed according to different tax brackets: the higher the income, the higher percentage owed in taxes. Not surprisingly, this is how the government gets the bulk of its income – from you, the individual taxpayer. Tax Policy Center, using 2019 data, gives a breakdown of government revenue sources: 50 percent from individual income tax, 36 percent from social insurance tax (including Social Security, Medicare, etc.), 7 percent from corporate income tax (taxing the profits of corporations), 5 percent from “other” sources (estate/gift taxes, customs duties, miscellaneous fees/charges etc.), and about 3 percent from excise taxes (such as taxes on cigarettes, alcohol, gas, airline travel, etc.).

For many people, actually paying taxes to the federal government is completely transparent to them, because their employer pays their taxes by “withholding” money from their paychecks and sending it to the federal government on their behalf. This includes federal income tax, Social Security tax, and Medicare tax. Sometimes other state income taxes or charges are withheld from paychecks also, depending on where you live or work (in Washington state, we do not have a state income tax).

According to IRS Topic No. 751, workers pay 6.2 percent of each paycheck toward Social Security, and their employers pay another 6.2 percent for a total of 12.4 percent. For Medicare, workers pay 1.45 percent of each paycheck and employers pay 1.45 percent, for a total of 2.9 percent. Stay with me! Like we discussed previously, for income taxes, employers withhold money based on an employee’s W4 form (which you likely had to fill out when you started employment, switched jobs, got married, or had another large life change that would impact your tax situation). Form W4 tells the employer how much money to withhold in taxes based on your personal tax situation and preferences.

Numerous factors influence withholdings, such as whether you are single versus married, whether you file jointly with a spouse, whether you have additional income besides your primary job, whether you take the standard deduction or itemize, and many more. Also, as of 2020, the IRS changed how tax withholdings are calculated on Form W4. It’s a more finely-tuned process; numbers such as “1” or “5” are no longer used as in previous years. If you haven’t already, it would be prudent to consult with a tax professional or take a few minutes to plug your income numbers into the surprisingly-intuitive Tax Withholding Estimator on the IRS’s website, to ensure you’re on track. Then, update your W4 with your employer. If you don’t, you may end up with too much or too little tax withheld from your income.

The reason millions of Americans receive money back from the IRS annually is because they have too much tax withheld from their paychecks throughout the year. Once things are reconciled by filing your taxes, the government refunds you for what you overpaid to them that tax year in the form of a “tax return”. You essentially gave the government a free loan, and they are paying you back with zero interest. Pragmatically, it would be much better to have access to that money throughout the year as you earn it – then you could pay off debt, save, invest, or otherwise usefully spend your money rather than entrusting it to the IRS so they can give it back to you.

But again, to be frank, tax return money is sadly the closest many Americans get to actually “saving” money, and only because they have no choice – their employers take it from their paychecks and pay the federal government, who returns it to the worker. However, if you can afford to overpay the government just to get that money back each year, you can afford to adjust your withholdings, then save or otherwise wisely use that additional money you now keep. Exercise some willpower, make a budget plan, and “pay yourself first”!

Best practices suggest examining your withholdings twice each year to ensure you’re having the appropriate amount of taxes withheld. Depending on your tax complexity, you should do it at least annually, at the beginning of the year. A perfect withholding calculation would result in no money back from the government when you file your taxes, and you wouldn’t owe any additional taxes either.

But what if you’re self-employed, work in the gig economy, or have other large amounts of income throughout the year on which tax is not withheld? These increase tax complexity a bit, but let’s simplify: since nobody is withholding taxes from your paycheck, to avoid paying penalties for paying late or not paying enough tax as you earn income throughout the year, you’ll likely need to make estimated quarterly tax payments to the IRS based off your estimated annual income and any deductions. For self-employment, you’ll also owe higher Social Security and Medicare taxes, since you don’t have an employer to pay half for you – you are your employer! It’s important to account for all these taxes; one way is opening a high-yield savings account and stashing away a portion of each paycheck to account for what you’ll owe.

Similarly, if you sell investments and they are not in a tax-advantaged account (such as Roth IRA or HSA), and they have appreciated in value since you bought them, you are required to pay taxes on that increase, known as capital gains. These tax rates vary depending on how long you have owned the investment before selling, and the amount of gains could push you into having to pay estimated taxes throughout the year. Many amateur stock traders mixed up in the recent GameStop stock fiasco and unfamiliar with how stock sale proceeds are taxed may have a rude awakening come Tax Year 2021!

Additionally, concerning tax deductions: due to the change in tax laws several years ago, almost 90 percent of taxpayers now choose the “standard deduction” when filing, according to TurboTax. This is a fixed number an individual or family can deduct from their taxable income, lowering their total tax bill. Itemizing, on the other hand, involves keeping detailed records of tax-deductible expenses to write off, but this is not practical for most taxpayers. While itemizing can lower your tax bill substantially, in 2021, a single person and married couple would have to exceed $12,550 or $25,100 respectively in write-offs for itemizing their deductions to be worthwhile.

Come springtime, you can file your taxes a number of ways. The easiest may be having an accountant/tax professional prepare your taxes for you by supplying them with the necessary paperwork, though this can get expensive. If comfortable, you can self-file via software such as TurboTax, H&R Block, and TaxSlayer, which can cut costs substantially. Some services even let you complete and file your taxes for free, depending on your income and the simplicity of your tax situation. Since I am comfortable filing our taxes, we use a combination of the above: we self-prepare, involving a professional if needed to answer specific questions.

Actions you can take today, right now: Always give consideration to how income you earn will be taxed, especially if you start a side gig, are self-employed, have a large change in salary, buy a home, sell/own investments, etc. Calculate your proper withholdings and update Form W4 with your employer as needed. Don’t hesitate to get a tax professional, they are invaluable. Gain a basic understanding little by little, begin preparing ahead of time, and you’ll be in for fewer surprises come tax season.

Luke Miller is passionate about helping others succeed in their finances, careers, and lives. A fourth-generation aviator, he is a pilot for a Seattle-based major airline. Luke and his wife live locally in Enumclaw. This article is based on the author’s opinions and recommendations alone and is not intended to be a source of investment advice.

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