How Do Taxes Work?

It’s coming to the end of the year, which means a few things. Colder weather, the Holidays and most importantly… tax season. (Okay, fine. Tax season isn’t that important, but it is important). In this post we’ll talk a little bit about how your taxes work.

Federal and State Taxes

Taxes are calculated on both the federal and state levels. These tax rates are established by federal or state governments. The federal tax rate is the same for everyone in the country, regardless of where you live or what you do for a living. Then, your state tax will differ depending on which state you live in. For example, if you live in California, New York or Massachusetts, you will pay a decent amount for state taxes. On the other hand, if you live in states like Nevada, Florida or Texas do not have a state income tax. Depending on how much tax you paid out of your weekly paycheck, you would either owe taxes or be given a refund at the end of the year.

How is My Refund Calculated

When you get your W-2 at the end of the year, it will list how much came out of your paycheck during the year for federal and state taxes. The salary you made, plus any other types of income such as dividend, capital gains, real estate or business income, will be added to your W-2 income. This would be considered your total income.

After this, your deductions and credits are subtracted from your total income. Types of deductions include mortgage interest, medical costs or real estate taxes. Credits include things such as student loan interest, educator expenses or college credits. Keep in mind, depending on your financial and life situation, some of these credits and deductions may not be applicable to you. To see some options for deductions and credits, check out this article, here.

Once you subtract out your deductions and credits, you will be left with your taxable income. This taxable income amount would be multiplied by your tax rate to give you the amount of tax you should have paid for the year. This is then compared to the amount you actually paid. If you actually paid more tax than you were supposed to, you will get a tax refund. Vice versa, if you paid less than you were supposed to, you will owe more money. If that is a little confusing, don’t worry, we’ll get into an example later.

How is Tax Calculated

The federal tax rates set as an incremental tax. This means that the tax bracket you are in does not mean that all of your income is taxed at that rate. Let me explain, here are the current tax rates for 2020.

how do taxes work?

The best way to explain this will be by example. Consider you are single and make $170,000 a year. This would fall in the in the 32% tax rate. A common misconception is that not all of the income is taxed at 32%. I have heard horror stories of people not taking raises because they think all of their income will be taxed at a higher rate. This is not true.

In this example, only the amount over $163,301 will be taxed at 32%, not all of the income. To further explain, the first $9,875 you make this year (that anyone makes) is taxed at 10%. Then any dollar you make from $9,876 to $40,125 is taxed at 12% and so forth.

Overall, you would owe $35,415 in taxes on $170,000 in income. To compare, if you thought it was 32% tax on ALL income, that would be $54,400 in tax. BIG difference.

So, if you actually paid $50,000 in federal tax through your paycheck, you would get a $14,585 refund. If you paid $30,000 in federal tax, you would owe $5,415 more.

The Key To Lowering Your Tax Bill

Taxes aren’t that difficult to understand at a basic level, we just aren’t taught how they work. Basically, if you want to legally decrease the amount of tax you owe to the government, you need to get more deductions and credits. The more you can subtract from your total income, the better. If you want to learn more about lowering your tax bill, check out our post on 5 Tips to Getting a Bigger Tax Refund.

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