Understanding Taxes for Beginners

Not sure how the tax system in the US works? Check out our beginners guide below!

December 10, 2021

Understanding Taxes For Beginners

The tax code is obviously incredibly complex considering it's 70,000 and more pages long and no one in their right mind has the time or energy to read all those.

This isn't the most exciting topic in the world, but as a citizen of the United States, you need to have a basic understanding of how the tax system works. Not only to make sure you're not breaking any laws, but also to keep an eye on your tax bill and make sure you're not overpaying Uncle Sam.

Let's dive in.

There are two important factors for really understanding the tax code:

  • Marginal Bracket System
  • Effective Tax Rate System.

How Does the Marginal Tax System Work?

The marginal tax system works like this; as you make more and more money, you're going to pay more and more tax in terms of percentage, and also just pure dollar figures.

10% Tax Bracket

If you make zero to $9,875, as a single person, then you're going to pay 10% on that income and if you make zero to $19,750 as a married couple and are filing jointly, that is also in the 10% bracket.

12% Tax Bracket

If you earn between $9000 and $40,000, you'll be in the next marginal tax bracket, and your income will be taxed at 12%. For example, any amount over $30,000 will be taxed at 12%. So, no matter what, the first $10,000 of income will always be taxed at 10%, while the greater amounts will always be taxed at 12%.

Effective Tax Rate

Assume you earn $100,000 per year. As a result, the entire $100,000 is exempted from the 24% tax. So, if you haven't received $1,000, you don't owe a $24,000 tax bill, which is the average of all of these tax bills. When it's all added up, it's probably closer to 16-18%. For a closer look at the tax brackets, make sure to check the irs website 

Make note of this because you'll want to ensure that you have some control over and a fair understanding of where those tax brackets fall. If you're earning more money but doing nothing to protect it, you may find yourself owing increasing amounts of taxes.

The 1040 Form

Every year, everyone is required to file an income tax return, which will be on Form 1040. This is the form that everyone must essentially fill, and it contains some of the information that the IRS (Internal Revenue Service) uses to determine how much tax you owe and ensure that you pay your taxes.

Information such as:

  • Your name
  • Your address
  • Whether you're married or single
  • Your social security number (tax identification number)
  • Different deduction dependents etc
  • Pensions etc

So that's going to be on here and that's how they're going to link the tax bill to you. We will go through what this all means later on.

Going back to the marginal tax bracket, the first line is what are your wages and salaries and that you're going to get a W two from your work or if you're a entrepreneur or maybe a contractor you may have a 10 Nine Nine, those are going to show what your income sources are.

And you may have other income sources such as taxable interest like this is interest from say, a bank account or a brokerage account, money that you make from those types of sources goes in this box. ordinary dividends, if you own stock and the company pays a dividend, that is also an income source that is taxable in the US.

Returning to the marginal tax bracket, the first line of the 1040 form shows your pay and salary, for this you would get a W2 from your job. If you're an entrepreneur or a contractor, you may receive a 1099, which will detail your income sources. You may have other sources of income, such as taxable interest, these would also be documented on the form. Ordinary dividends would likely be taxed in the United States if you hold shares and the corporation pays you a dividend. Some may be qualified or some may be ordinary. In this case, you would get what's called a 1099 B and a 1099T for interest, which will both show different amounts. On the 1040 Form, you also have IRA distributions (pensions) for a lot of people that may not apply unless you're in retirement.

Capital Gains

Capital gains are basically any money that you make from investments in stocks, bonds, mutual funds, exchange, traded funds and small businesses, you name it. The tax code is constructed in such a way that it benefits capitalism. It rewards business owners or investment in businesses. There are two types of capital gains. Short-term capital gains and long-term capital gains. If you bought and sold stock during the year or bought mutual funds, those can incur capital gains. With that, you have different sets of income for investing in companies.

Short Term Capital Gains

Your income rates (mentioned above) may be as high as 37 %. If you invest in stocks and retain them for less than a year, you're considered a speculator rather than an investor, which means you will still be taxed as though you were earning money.

Long Term Capital Gains

However, if you invest in companies that hold their stock for a year or you own a small business you start to obtain favorable tax treatment. So, if you hold stocks for more than a year, you can have 0%, 15%, or 20% on that tax, instead of that money you made (37%) just because you held it for one year, which they reward to you as being an investor.

In a nutshell that's what capital gains is.

So any capitalistic investments that you make, you have the chance to earn money back on your taxes just by investing in those types of companies instead of being an employee. So if you have this capital gain, it would be recorded on the 1040 Form, and you would get the 1099 form from your brokerage company, for example.

So that covers all the income coming in.

Moving on to the good part, yup, you guessed it, deductions and credits.

Deductions vs. Credits

As a citizen of the United States, you have what are known as deductions and credits.

These are things that whittle down your taxable income to ultimately get to what is called your adjusted gross income or your actual taxable income. So you start with the raw gross statistics and work your way down from there.

  • Tax credits directly reduce the amount of tax you owe, giving you a dollar-for-dollar reduction of your tax liability.
  • Tax deductions, reduce how much of your income is subject to taxes.

Deductions

A charity donation or a contribution to your retirement savings account, such as a 401k or an IRA, are both examples of tax deductions.

Let's say you make $100,000 per year. If you donate to a charity or contribute to a retirement account, or other scenarios that qualify you for a deduction, you basically have a $20,00 deduction and just $80,000 of income for tax purposes.

Going back to the original tax brackets, if you earned $80,000, you'd be in the 22 percent tax bracket. So, if you had $100,000, you will save between 21% to 23% on that $20,000, on average. So you saved $4,000 in taxes only by taking use of that tax break.So that is how a deduction works.

Note that deductions do vary depending on whether you're a small business owner or just an employee.

Credits

So credit is a little different. As we mentioned above, tax credits directly reduce the amount of tax you owe, giving you a dollar-for-dollar reduction of your tax liability. So meaning, if you have $1 owed in taxes and $1 in credit, you now have zero taxes owed. There are different credits available out there that can essentially knock out $1,000s of dollars on your tax bill.

Where you have your deductions, most people are going to file what's called the standard deduction or an itemized or an extended backtrack.

The majority of Americans accept the standard deduction, which amounts to $12,400 this year for each person in terms of tax deductions allowed.

For example, if you earn $100,000 in the United States, your taxable income will now be $100,000 minus $12,400, resulting in a total of 87,600. If you have more deductions than $12,400, you can itemize your deductions, which allows you to figure out exactly what each of your line item deductions is and write them off separately.

If you own an expensive property and you have a high mortgage interest, that's a deduction that you can write off. If those add up to more than $12,400, for an individual, or double ($24,800) for married couples, then you can do what's called an itemized deduction. You have your income, then your deductions, and then when that chips away, you then have your taxable income. All of this information will be requested on the Form 1040. So now you have your total tax that you'd pay on your taxable income, and you've got your tax brackets, which tell you how much tax you owe.

You may now use your various credits to effectively eliminate the tax. And once you've had that tax wiped off, it'll tell you exactly how much you owe the government. Or, to put it another way, you'll get your paycheck throughout the year, and they'll withhold taxes from it automatically.

Tax Refunds

At this point, you might discover that they withheld too much tax as a result of this. And so that's how you get a tax refund. For example, let's say you withheld $20,000 out the year, but you only actually owed 15. The 1040 form will reflect that you paid $20,000 and now you only owe 15. So then a $5,000 refund is owed to you.

Filing Your Taxes

There are many services available to help you submit your taxes. Companies like H&R Block and TurboTax allow you to file your taxes online. These types of businesses can help you file your taxes online, and the government even offers a free version you can check out.

Alternatively, if you don't want to, you can engage any number of tax specialists, such as H&R Block, who are all tax professionals. This is a shameless plug for Vincere Tax. For example, like other tax agencies, we take all of the work and complete it without you having to do anything and submit your taxes for you.

Whether you choose us or another service, there are hundreds of thousands of options for filing your taxes if you don't feel comfortable doing it yourself. But ideally, with the knowledge you've gained from this blog, you'll feel comfortable dabbling in it for the first time and paying your taxes and just walking the tax agency hrough all the questions.

If you do use a tax agency like H&R Block or TurboTax, they're gonna ask yo lot of different questions, but the bulk of questions would be based on:

  • What's your income?
  • What are your deductions?
  • What are your credits?
  • How much tax do you owe?

Hope you found this helpful!

Drop any questions you may have below. Would love to hear from you.


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