Episode 198: November 17, 2010
by Laura Adams
Taxes are probably the most confusing topic in the world of personal finance. In my new book that’s coming out next month, Money Girl’s Smart Moves to Grow Rich, I cover everything you need to know to create a secure financial future—no matter how much or how little you have. Chapter ten will help you make sense of taxes and teach you how to legally pay less. I boil it down to what you really need to know, without trying to turn you into a tax accountant.
You may wonder why you need to know anything at all about taxes. The reason is because many people pay more in taxes each year than they do for their mortgage or rent. That means falling prey to a common misconception about taxes could cost you a bundle. So, let’s start by busting five common myths about federal income tax.
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Income Tax Myth #1: The Poor Pay a Bigger Percentage of Their Income on Taxes
In the United States our income tax is called a marginal or progressive tax because it increases as you make more money. In other words, the more you earn the more Uncle Sam takes out of your wallet on a percentage basis. Someone who earns $100,000 shells out over 22% of their money for federal taxes on average, whereas someone who earns $30,000 only pays about 13%. That may still be a relatively large amount for someone who’s struggling to make ends meet, but it’s not a higher percentage of their total income.
Income Tax Myth #2: Your Tax Bracket Is the Tax Rate You Pay
If you’re in the 25% tax bracket, you’re entire income is not subject to 25% tax—that’s just the highest rate that’s applied to your top range of income.
A “tax bracket” is a range of income that’s taxed at a certain rate. Each bracket gets assigned a progressively higher rate, which means that the first dollars you earn are taxed the least and the last dollars you earn are taxed the most. There are six tax brackets for 2010: 10%, 15%, 25%, 28%, 33%, and 35%. If you’re in the 25% tax bracket, you’re entire income is not subject to 25% tax—that’s just the highest rate that’s applied to your top range of income.
The actual amount of tax you pay can be used to calculate your effective or average tax rate, which is always lower than your tax bracket rate. Simply divide the amount of tax you pay by your income. For example, if you’re a single taxpayer and make $35,000 in 2010, you’re in the 25% tax bracket—but your effective tax rate is just 14%. At moneychimp.com you can use the Federal Tax Brackets Calculator to find out how much tax you really pay based on your income and tax filing status. (Depending on where you live you may also have to pay state income tax, which raises your effective tax rate.)
Income Tax Myth #3: If You Get a Raise that Puts You in a Higher Tax Bracket You’ll Make Less Money
When you make more money and get bumped into a higher tax bracket, pat yourself on the back! As I mentioned, a higher bracket only increases the rate of tax that you pay on the last dollars you earn, not on your total income. So, no matter your tax bracket, getting a raise always means that you take home more money.
Here’s an example: Let’s say you’re a single taxpayer who made $34,000 in 2009. That amount of income put you in the 15% tax bracket. But you get a small raise in 2010 and will make $35,000 this year. You realize that the cut-off between the 15% bracket and the next highest, 25% tax bracket is $34,000. So, should you worry about getting bumped from the 15% bracket into the 25% bracket? Absolutely not!
Here’s why you should be thrilled to move into a higher tax bracket: Your income won’t be taxed any differently—except for the amount that falls within the top 25% tax bracket, which is just $1,000. Again, the tax bracket cutoff is $34,000 and you’re going to make $35,000. The last $1,000 you earn is the only amount that will be taxed at 25%, instead of at 15%. So getting a $1,000 raise only costs you an extra $100 in taxes (10% of $1,000). That means your raise puts an extra $900 in your pocket after-taxes.
Income Tax Myth #4: Income Taxes Are Higher Now Than Ever
Taxfoundation.org has a great chart of the tax rates from 1913 through 2010. It’s interesting to look back and see how much our tax system has changed over the years. For instance, in 1913 the top tax rate was 7%, but by the mid-1940s it was 94%! As I mentioned, for 2010 there are six tax brackets that go from 10% up to 35%.
Income Tax Myth #5: There’s No Way to Lower Your Taxes
As complicated as taxes can be, there’s no reason to pay more than you have to. In a recent article, How to Use Tax Shelters to Save Money, I gave you five legal ways to reduce your taxes. Here are three more tips for ways to pay less tax and save more money:
Deduct job-hunting and relocation expenses. When you’re looking for a job in a similar trade or business, you can write off certain unreimbursed expenses—like headhunting fees and travel, even if you don’t end up finding a job. For more information be sure to read my article, Tips for Job Seekers.
Deduct vehicle expenses. When you use a vehicle for certain purposes—such as doing business, receiving medical care, or performing charitable service—some or all of the cost is tax-deductible. For more details take a look at IRS Publication 463.
Give to charity. Whenever you make a donation to a qualified organization or charity—like Goodwill, Red Cross, or a church—you can claim it as a tax deduction, as long as you itemize deductions on your return. Just be sure to get a receipt for your records with a description of what was given.
Missing legitimate tax deductions or tax credits is like donating your money to the government, so be sure not to overlook them. Tax mistakes cost money, so hiring a qualified tax preparer or accountant to do your taxes can be a very smart investment.
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