How do taxes work? Your guide to understanding taxes and how they actually work.

May 04, 2022 5 min read

The Money Bag Newsletter by Financial Footwork

 

How do taxes work?

This is your beginner’s guide to understanding taxes and what they mean for you.

Taxes, that big ugly word that stresses everyone out. Uncle Sam is on time, every time when it comes to getting his cut of your hard earned cash. So let’s break down how taxes actually work and what you need to know.

 Let’s break down how taxes actually work and what you need to know in order to file your taxes.
Overview of what you will find in this article:
  • Pay where you play (State & Fed taxes)
  • Standard deductions
  • Tax Brackets
  • Taxes Deadlines 
  • Extensions

 

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    State & Federal Taxes

    Let’s start with who you have to pay. There are two main tax returns you need to file, your federal tax returns and your state tax return. 

    Federal Taxes are your “rent”, the fee you pay for living in the US. You get to use the services provided in this county and the government gets a check to cover social programs, infrastructure (roadways and schools), Medicare, national parks, prisons, etc. 

    State taxes are the pay where you play tax. Every state has a unique tax structure. States have Income tax or sales tax or both! It’s important to understand the tax structure where you live, since we have 50 states to discuss. I'd be happy to do a video going through the tax structure by state, comment below if you’d like to see this! 

    Now that we know the basic returns that need to be filed. Let’s talk about the Federal tax structure in the US and how it works.

    Breaking down the Federal Tax System

    We have a marginal tax system in the US, not a flat tax. As your income steps up, your tax rate does too but you are not taxed the same amount on every dollar you earn. 

    SINGLE FILER

    (Nerdwallet.com - 2022)

    This is the tax chart for 2022, these tax rates will apply to the tax returns filed on April 2023. This specific chart is for people filing as single filers (not married). 

    As you can see, the chart outlines the tax rate based on the income tier you fall into.  Let’s break down an actual example of how the tax rate works.

    Let’s say you made $78,000 this year. You would fall into the 22% tax bracket. 

    You will pay a tax amount of $4,807.50 up to $41,775, the first $41,775 of your income is taxed at a lower rate based on our marginal tax structure.

    Any funds OVER the $41,775 will be taxed at 22%. 

     

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    MARRIED FILING JOINTLY

    (Nerdwallet.com - 2022)

    Now let's look at the same chart for couples who file their taxes jointly. 

    Let’s say a married couple made $198,000 in total combined income this year. The tax bracket this couple would fall into the 24% tax bracket. 

    You will pay a tax amount of $30,427 up to $178,151of your total income, that means the  first $178,151 of your income is taxed at a lower rate than the remaining income you’ve earned over the tax bracket minimum.

    Any funds over the $178,151 will be taxed at 24%. 

    As you can see, the US operates on a marginal tax tier and your taxes are charged according to your earned income.. The tax tiers do change annually, so you will want to look at the tax tiers for the given tax year we are in. 

    Pro Tip:

    For those of you concerned about moving up in pay and bumping to a new tax bracket. Keep in mind that your income will be taxed at the same rate, until you move up to a new tax bracket, only the amount of income OVER the tax bracket tier will be charged at a higher tax rate.  It is always good to get a raise and make more money. 

     

    Standard & Itemized Deductions

    Now for some good news! Once we have our yearly income numbers (or an estimate of it) we are not actually taxed on the exact amount we earn. Yes, you heard that right! There is a little bit of a saving grace in the “deductions” we get to apply to our taxable income.

    Each year, the federal government applies either astandard deduction oritemized deduction to your earned income, reducing the amount you are taxed on. 

    Let’s start with standard deductions.

    This chart is for taxes being filed in April of 2023. 

    2022 Standard Deduction Chart

    If you are a single filer, your standard deduction will reduce your earned income by $12,950

    Let’s use our first example, our single filer made $78,000 in total income, he would deduct $12,950 from his earned income which gives him his Adjusted Gross income number or AGI. This is a term you will see frequently in the tax world and when you are filing your taxes 

    Looking at his numbers, $78,000 - $12,950 he lands at an AGI of $65,050. This is his taxable income. 

    For a married couple filing jointly, your standard deduction reduces your earned income by $25,900

    In the case of our married couple example, they earned $198,000 in joint income, deducting off the $25,900 they are left with an Adjusted Gross Income (AGI) of $172,100.

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    These are the nuts and bolts of how standard deductions work and there are other deductions that may apply based on how you earn your income. For now, getting a basic understanding of the system is what we are going for.

    So when do itemized deductions come into play?  Many people ask, how do I reduce my taxes? Itemized deductions are one of the main ways, here are the main categories for itemized deductions:

    • Mortgage Interest
    • Property Taxes
    • State or Local Income Tax
    • Unreimbursed Medical expenses
    • Charitable Donations

    If your itemized deductions, the things you can write off, are higher than the standard deduction threshold, you would use the itemized deductions to reduce your Adjusted Gross Income, saving you more money on your taxes.  

    Tax Filing Dates

    Taxes are due April 15th every year, in some cases that date might be changed based on the actual day the 15th falls on. For Example, in 2022, taxes were due on April 18th. Giving everyone 3 extra days to get their returns filed.

    File your taxes on time every year, no need to pay interest to the IRS for being late when filing your return. It’s like a credit card payment, if you are late there are penalties. Treat your tax returns with the same care and file on time.

    If you cannot file your taxes on time, you own a business, you were recently married and are filing jointly for the first time, etc. You always have the option to file a Tax Extension, this allows you to postpone filing your taxes at no cost for a specific amount of time. You will be given an extension due date when you file for an extension, make sure you meet the due date for your extension.

     There you have it, a basic guide to the types of taxes you will need to pay, how the tax system works, and when taxes are due.

      

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