Tax Jargon for Millennials.
This is a beginner blog post for people who don’t know anything or know very little about the tax system.
I have recently started working in the USA, and I knew nothing about taxes. I did not know when to pay them, or how to pay them. My time for reckoning came when I came across a video on youtube about how I could save on taxes if I registered as an LLC. Although I am not that well versed, from my research, yet to help you figure out if and why you should register as an LLC, I will help you understand, as best as I have understood, the Tax Jargon for the USA.
In this article, I will discuss only the Income Tax. I will discuss some of the basic terminologies. I will give a basic introduction on how to file for taxes.
PS:- I am not an accountant, and you should consult a professional for your needs. I am simply giving you a platform to understand what your accountant is talking about.
Components of taxes.
Federal taxes are taxes you owe the federal government. This is also collected by the IRS. The federal tax rate is the same throughout the country, and you must pay it every year. The rate of tax varies from year to year. The current tax code can be found here.
Apart from federal taxes, most states require you to pay an additional state income tax. This state tax depends on the state you live in and earn your income in. If you work and reside in different states things get a little complicated and extra research is due.
The tax rate of each state varies. You can find the state tax rate here as of 2020.
Interesting fact: As of 2020, 9 states have no state income tax. These states are Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. However, you are still required to pay federal income taxes in these states.
Tax slabs are how income tax is calculated. You can think of it as steps, and you divide your money and put them on each step. Each step is associated with a percentage.
For each step, you pay the percentage of tax denoted by the step on the amount you place on that step.
Assume a simplified tax slab as shown in the picture above. And let’s say you earn 700,000 $ a year. You DO NOT have to pay 40 % on the entire 700,000$. You will have to pay 10% on the first 1000$ you earn, 20% on the next 9,000$ you earn, 30% on the next 90,000 $ you earn, and finally 40% on the remaining 600,000$ of your income.
This will come out to be:
0.1*1000+0.2*9000+0.3*90000+0.4*600000 = 268900
This means according to our fictitious simplified tax code, you will owe 268,900 $ in income tax annually. This is lesser than the 280,000 $ you would’ve paid had you paid 40% on the entire amount.
The tax slabs for 2020 USA can be found here.
Deductions and Credits
A tax deduction is an amount you can reduce from your total annual income, so you pay Income tax only on the reduced total Income. An example would be the interest on your mortgage. If you earn 200,000 $ annually but pay 10,000 $ annually on the interest for your house mortgage, Then you can apply for tax deductions, and subtract 10,000$ from the 200,000$ income. Now you pay taxes only on 190,000$ rather than the full 200,000$.
There are 2 types of deductions, standard and itemized deductions. I will not get into these now, maybe in another blog post.
Tax credits are reductions you can make in the amount of tax you pay. This is an extremely powerful tool. Think about the following situation:
You pay 50,000$ in taxes. And let’s assume there is only one tax slab at 10%.
Now if you get a tax deduction of 1,000$, that means you pay a 10% tax on 49,000$. Which comes out to 4,900$ of taxes paid. However, if you got a 1,000$ tax credit, now you pay 1,000$ lesser in taxes. So in this scenario, you pay only 4,000$ in taxes. In our particular scenario, the tax credit saved 900$ over the same amount in deductions.
The numbers are not important, just remember tax credits reduce the tax amount, while deductions reduce the taxable Income amount.
You can qualify for tax credits in a number of ways, I will not get into it now. Maybe in another blog post. :)
Filing for taxes
Filing taxes refers to filling out the correct forms required by the IRA and your state, to pay the taxes that you owe. Most employers will deduct pay to account for taxes, this way you have been paying taxes throughout the year instead of in one lump sum at the end. Even though you may have only one source of income (ex. Wages), and your employer has withheld taxes from your paycheck, and paid them to the IRA, you may still want to look into filing taxes. These can be either because you have earned extra income, or you think you are eligible to tax deductions and credits. There are 3 major ways you can file your taxes.
- The first method is to Learn the IRS and state tax code and fill the forms manually.
The Pros of this method are:- it’s free, you know your tax situation best and might be able to get the best returns and pay lesser.
The Cons of this method are:- it’s relatively complicated and time-consuming.
- The second method is to hire a tax professional, either a certified personal accountant or a licensed member from the IRA.
The Pros of this method are:- you get personalized attention and solutions to help you save. This method is also particularly helpful if you have a complicated tax situation.
The Cons of this method are:- It’s the most expensive approach. You also have to do research on your accountant to find a well-qualified accountant.
- The third method is to use tax software. These are a good in-between method, that has some qualities of both previously mentioned methods.
The Pros of this method are:- It’s cheaper than hiring a professional and easier than learning the tax code. It’s fast and efficient.
The Cons of this method are:- It’s not very personalized and is a more generic approach. If your tax situation is complicated, this might not be the best option for you.
Most software offers free services when your annual gross income is lesser than a certain value. Check out different software and their features and pricing before making a decision.