Ah, taxes! We all love to hate taxes, no matter what type of tax it is. It is a necessity in order for civilization to function (maintenance of public roads and utilities, military, parks and recreation, the list goes on) but it still hurts when we see our hard earned dollars disappear into the government coffers. However, if instead of complaining about our taxes we spent the time researching and embracing the topic, we would be so much better off. Let me give a disclaimer here. I am NOT a certified tax adviser CPA, or any other official capacity that gives me the right to advise you on how to do your taxes. My goal is not to tell you how to do your taxes, but rather to get you thinking about managing your taxes and get you started learning how to take control of your taxes rather than having your taxes control you.
One thing that I want to make sure you understand is that your taxes make a big difference in your financial health. Think about it, how much of your hard-earned income goes to the government in the form of taxes, 20%, 30%, or 40%? The management of your taxes affects how much money stays in your pocket. When and how you make and spend your money can affect your tax expense and some minor considerations can make a huge difference. One thing that continues to stand out is that most of the people that I talk to struggling financially complain about taxes but have no understanding of them. Interestingly, most of the financially secure people I talk to have at least some understanding of their taxes and how to managing them. Coincidence? I highly doubt it. Actually, I know for a fact that managing your taxes is one of the major reasons some people advance and some people fail with their money. Wow, sobering isn’t it?
Playing games with the IRS
I have to mention something that is critical when talking about taxes. There is a difference between trying to minimize your tax expense and trying to cheat on your taxes. Minimizing your taxes means taking advantage of various tax codes, exceptions, deductions, exemptions, etc. the way that they were designed to be used. Committing fraud on your taxes is when you try to fudge the rules, use exemptions and deductions that you don’t qualify for, and lie about income and expenses. Let me be VERY clear here. DO NOT PLAY GAMES WITH THE IRS! Not only is it immoral, unethical, and illegal, but the IRS has almost unlimited power and resources to pursue anyone they think might be committing fraud. They will garnish wages, tap your accounts, and pretty much ruin your life. Oh, and did I mention that it is one of the few cases where you are guilty until proven innocent? Are you getting the picture yet? I frequently come across people who think they can push the boundaries with the IRS. Like I said earlier, don’t play around with the Internal Revenue Service! Stick with legal, legitimate ways to lower your tax burden.
Refunds
Let me mention the topic of withholding and get a refund every year. Many people are very opinionated on this topic, and as such I think I need to address it. Basically, if you get a large check back from the government every year, you are giving the government an interest-free loan with your money. Remember, the government is not giving you money, they are simply returning YOUR money to you after having used it for a year for free. You might want to consider changing your W4 withholding so that you get the money and not the government. It is vital, however, to be disciplined and put the money in savings and not spend it.
The key is not to be intimidated by looking at your taxes, rather embrace the opportunity to improve your life. The less you know about something, the higher your stress level when you are forced to confront it. This applies perfectly to income taxes; we all have to face the music every year so it only makes sense to be informed.
Ok, enough of my soapbox. Here are some of the most common terms and definitions that you will find when dealing with taxes and CPA’s. The more familiar you are with the lingo, the easier it is to talk to your accountant and the easier it is to do self-study.
- Adjusted Gross Income (AGI) – This is your starting point. Your AGI is simply how much money you made that year from all sources. The “adjusted” part is because there are some things that are taken out like alimony or some business expenses.
- Tax Deductions – Deductions are subtracted from your AGI (which reduces the amount you are taxed on)
- Standard – The IRS offers everyone a standard deduction amount that can be used if you don’t want to itemize your deductions (most people use the standard deduction)
- Itemized – The IRS allows you to itemize a number of various things like charitable contributions, state income taxes, mortgage interest, to name a few examples. However, this only makes sense if you have enough items to exceed the standard deduction amount.
- Taxable Income – Your taxable income is what is left over after your deductions are subtracted from your AGI. This is the amount that your tax rate is applied to in order to determine your tax amount. (Make a mental note of the difference between the Adjusted Gross Income and the Taxable Income.)
- Tax Credits – Tax credits are significantly different from deductions. A tax credit is subtracted directly from your tax bill, where a deduction comes off earlier from your AGI. Basically, a tax credit has a more drastic effect on the money leaving your pocket than a tax deduction.
- Exemptions – The gracious people at the IRS allow you to deduct a set amount for each person that relies on you to bring home the bacon (called a dependent). Just make sure that you have the right to claim that person as a dependent.
- W4 – You are probably familiar with a W4 since your employer asks you to fill one out on occasion. This is where you choose how much to withhold out of your paycheck. The key to note is that if at the end of the year you are receiving or paying a large sum to the IRS refund, you need to request a W4 form from your employer and change your withholding.
- W2 – Ok, I am sure you probably know what a W2 is, the report at the end of the year saying how much you made and how much you paid in taxes. Most of us only care about our W2s because we need them to do our taxes and get a car or house loan, but please take a minute and consider how much of your money the government took from you and think about how they used it. Remember, when people talk about government waste, it is your money being wasted.
So why should you care about these and other key terms related to your taxes? I mean, really, why not just worry about them at tax time? These are things that you need to know when getting a loan, making purchases that claim to be cheaper than the price because there is a tax credit or deduction involved. How about standard vs. itemized deductions? Many people can save money on their taxes if they kept track all year of eligible items that they can claim as deductions, but they only think about it at tax time, and all records are gone. My point is that you should spend some time thinking about your taxes, do a little bit of study, and you might just save yourself some money and stress!
I recommend that you spend a little bit of time at the Internal Revenue Service’s website looking over topics that apply to your situation to familiarize yourself with various ideas and issues that affect you. Don’t worry, the IRS site is actually not that bad to navigate and they do have some good stuff, even if it is hidden in government red-tape speak. However, I have to confess that second-party sites tend to provide clearer information and better tools. I particularly like TurboTax’s Tax Calculators and Tax Guides for ease of use. This is a good place to calculate your W4 calculations and get some ideas on tax planning.
Ok, time for my shameless plug for my favorite tax program. I have used TurboTax for years and love it. I have used other programs and personally prefer TurboTax.