physcalTherapy is a blog covering personal finance basics as well as irrational behaviors, common myths and the lies we tell ourselves that prevent us from achieving financial health.

Taxes for Dummies

Taxes for Dummies

It's April... springtime and tax season! This year I volunteered for this program that provides free tax preparation for folks who don't make too much money. After working with many clients, I've come away with a few observations - for many, taxes means big money and for a few, it means big disappointment when they didn't get the big windfall they had hoped for. For everyone, taxes are a mysterious, complicated thing that cannot be understood. I hope to shed a bit of understanding to this mysterious thing so we know what to expect and so that we don't experience big disappointment in the future.

So to start off, I'm going to tell a story. This is a fictional story, for illustration purposes only, mostly because I don't like history and am too lazy to go look up the facts

Once upon a time, there was a fledgling country that needed money for the country's expenses. They decided the best way to do that was to ask everyone to chip in a little bit each. Each person would give a part of their income, say 10%. Everyone would calculate how much money they made each year and give 10% to the government. But then they realized that it was a lot to ask people to save and put aside all that money until the end of the year (and some people are bad at saving so they wouldn't have enough). They thought it would be easier for everyone if they just took 10% out of their paychecks and thus paycheck withholding began. In time, people started thinking that it made more sense for richer people to pay more, so they introduced many different percentages and richer folks paid higher percentages and poorer folks paid the least. This made withholding complicated, especially if you had more than one job, because they didn't know exactly how much money you were going to make, which meant they didn't know which percentage to use. Sometimes they withheld too little, sometimes they withheld too much. So every year, there would be a day of reckoning. Everyone would fill out a form to record what their actual income was for the past year and if the government withheld too little, then you'd have to pay extra to make up the difference or if the government withheld too much, they'd give you the extra amount back. And thus 'tax day' was born.

While the story was made up, it is true that the government assigns different percentages (tax rates or tax brackets) to different people with richer folks paying more and poorer folks paying less. It is also true that the government withholds money from folks who receive a paycheck. If you run a business and don't receive a paycheck, then there is no automatic withholding, you need to do-it-yourself-withholding also known as filing 'estimated taxes'.

So, why are taxes so complicated? Isn't it just adding up all your income (aka taxable income) and multiplying by some tax rate? Unfortunately... not even close. The government decided that this taxes thing was a very powerful tool to either get people to do what they wanted or keep people from doing things they didn't want them to do. Like for example, if we want people to use environmentally friendly cars, let's give everyone a discount on their taxes for buying one. 

Photo by  www.ccPixs.com

It might help to explain our complicated tax code in more familiar terms... shopping terms. Normal vanilla taxes are like the official price (MSRP) of an item. Some people just pay MSRP but many people don't. Lots of people take advantage of discounts, like store coupons, manufacturer coupons, corporate discounts and seasonal sales. Each of these things bring down the price but they do so in different ways with different rules. Similarly our tax code has many discounts which fall into three categories: adjustments, exemptions and deductions. In shopping, after you apply all the discounts and get your final price, you can still reduce your out of pocket cost in the form of store credit or rebates. In our tax code, there are similar credits called non-refundable and refundable tax credits.

Now in a tax system where there are many, many... many discounts and every person qualifies for a unique combination of discounts, can you imagine how hard it is to figure out the right amount to withhold? It's impossible! They always get it wrong! So by April 15, we all fill out forms to let the government know exactly how much we made and which unique combination of discounts we qualify for and then either ask for our money back or give them more money.

I hope I haven't lost you and you're still with me. I'll end with these practical takeaways:

  • Getting a big refund means the gov't withheld too much of your money:
    There should be no rejoicing when you get a huge tax refund. You should be upset! That money was sitting with Uncle Sam all year instead of in your bank account and they 'borrowed' it from you at 0% interest.
     
  • You can control how much Uncle Sam withholds:
    Did you know that you tell them how much to withhold? It's in a form called a W-4 and they usually make you fill it out when you start a new job. Of course they don't make it easy and just make it a dollar amount - they make it special code number and that number works counterintuitively. '0' means 'withhold-a-lot' and a big number like '30' means 'withhold-[almost]-nothing'. And you can specify a dollar amount (aka additional withholding) on top of the special code number (aka exemptions).
     
  • If you want a bigger refund, just withhold more:
    If my first point above doesn't resonate with you - if you don't care that Uncle Sam is holding onto money that could be in your bank account... if getting a big check every year is really important to you... or if you'd rather be safe than sorry and you hate owing money come tax day - then tweak the numbers on your W-4 so that your company withholds more.

There is so much more to say about the tax code (I find this stuff fascinating!) but I'll spare you the details and end here. But if there is anything in particular you want to hear more about (like how the Trump tax plan affects you or more about a particular kind of discount), lemme know in the comments!

 

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