If you’ve every filed your taxes in the U.S. then you know how complicated the U.S. tax system is. With this in mind it’s no surprise that many people find doing their taxes frustrating and most not understanding how their taxes are even calculated. These days, there are many softwares such as EZTax and TurboTax to help with filing their taxes. If you prefer a human touch, there’s H&R Block or local CPAs. So, you may be asking why do I need to know about taxes if there are so many resources available to me? I’ll let you in on a secret, wealthy people perform tax planning throughout the year (not just when they file their taxes). Having a better understanding of your taxes helps you keep more of your income by deferring your tax liabilities. Furthermore, there are other tax strategies that you can take advantage of that can permanently or temporarily lower your taxes. Keep reading to learn what you need to know about taxes.
Before we get started, let’s make sure you understand common tax terminologies.
- Gross Income – This is the total amount of money a taxpayer makes in one tax year (i.e. salary, investment income, alimony, lottery and prizes).
- Deductions – These are transactions that the Internal Revenue Service (IRS) allows you to subtract from your gross income.
- Taxable Income – This is the amount that remains after applicable deductions are subtracted from your gross income.
- Marginal Tax Rate – This is the percentage of every extra dollar you earn that is taxed.
- Adjusted Gross Income (AGI) – Income after For AGI Deductions.
Now let’s get into what you need to know about taxes.
Gross Income – Deductions = Taxable Income x Tax Rates = Tax liabilities + Other Taxes – Credits – Prepayments = Tax Owed.
Tax Saving Strategies
Contribute To An IRA
If you have a traditional Individual Retirement Account (IRA) that you contribute to through your company’s 401k, you are saving on taxes. The advantage of this type of account is that your contribution is tax deferred. This means you do NOT pay taxes on the money you contribute but instead pay taxes upon withdrawal. So, if you don’t have a retirement fund already, you need to open one today. Here’s a blog with all you need to know about retirement accounts [Traditional IRA vs Roth IRA].
Invest In Tax Free Assets
There are several types of tax free investments that you can buy to lower your tax liabilities. However, municipal bonds are preferred. Municipal bonds are debt instruments issued by state, cities and municipalities to fund public work projects. Bond holders receive semiannual payments that are tax exempt. That is, they are exempt from city, state and federal tax. Be certain to do your own due diligence as there are some cases where municipal bonds can be taxed.
Contribute To Charities
To encourage the public to engage in philanthropy, the IRS allows portions of charitable contributions to be exempt from tax. Persons can deduct a portion of their cash contributions and capital gains property contributions up to a certain limit. Taxpayers should keep several things in mind when determining if their charity contributions are deductible: 1) the deduction limits, 2) the type of contributions and 3) the organization that the contribution is made to. Visit the IRS website for more details on your specific situation [Charitable Contribution Deductions].
For our tax calculation example, we have some assumptions. Firstly, Jane makes $100,000 as an auditor for a private equity company. Her For AGI deductions total $10,000. Jane is unmarried and files as a single taxpayer with no dependents, therefore she qualifies for the $12,950 standard deduction. People who want to lower their tax liabilities generally focus on maximizing their deductions. See how we calculate Jane’s 2021 taxes using the 2022 IRA tax brackets.
Now that you’re more tax savvy, have fun filing your taxes! Just remember that tax planning should be done throughout the year, not just in April.
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