I love paying taxes! Okay, that’s a lie. No one likes to pay taxes. That is something every citizen can agree on. Unfortunately, taxes are an unavoidable part of life, therefore it makes sense that you learn as much as possible about how the tax system works. While there are many different forms of taxation, we are going to focus on income tax. This is the tax you pay on earned income. Here are a few things you should know about paying income tax.
Income is taxed with varying tax rates
Every individual who pays taxes on earned income pays a different rate on different amounts of money. For example, the first dollar earned is taxed at a lower rate than the last dollar earned. So while you are paying tax on all of your dollars earned, the tax rate varies at certain points. If you’ve been following the news, then you may heard some rumblings about the Bush Tax cuts getting ready to expire in 2011. In a nutshell, that may mean we’ll all have to pay more tax. Gulp. For now, I’m holding my breath 🙂
It's better to break even than receive a refund
Obviously a tax refund is better than owing a tax liability, however breaking even makes more financial sense. The reason for this is relatively simple. When you receive a tax refund you have essentially paid too much tax on your earned income. The federal government has basically received a interest free loan for the duration where as you could have used that money throughout the year for savings or investments.
Tax credits are better than tax deductions
Both credits and deductions will save you money but in different ways. A tax credit reduces the amount of taxes owed on a dollar-for-dollar basis. A deduction on the other hand reduces the amount of taxes owed by a percentage based on your tax bracket
Estimated tax payments
Individuals who are self employed or those who anticipate owing more money than withheld wages will cover should make estimated tax payments throughout the year. By paying your taxes four times per year (April 15, June 15, September 15 and January 15) you reduce the amount of taxes that you will owe when you file your income tax return. When I become self-employed in 2007, this was a big shock for me- having to pay this so called “estimated tax”. Once we got a system in place, it’s been a smooth transition and I’ll never look back to the W-2 side.
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It is better to file on time even if you owe money
If you know you will owe taxes on earned income and don't have the money to pay by the filing deadline, you should still file your tax return on time. Failing to file on time will increase the amount of money you owe as there is a separate penalty for late filers. How much is the penalty? Check out out my post on What happens if you don’t file your tax return on time. It is also important to note that while the taxing agencies may work out a payment agreement, fees and penalties on tax liabilities continue to accrue until they are paid off. For this reason it is highly recommended that you pay any tax liabilities in the shortest amount of time possible.
Not all income is subject to taxes
There are certain thresholds determining how much income you have to earn before being taxed. There are also different types of income that are free from tax, such as combat pay for military servicemembers. When I served overseas, all our income was completely tax free. While tax free income is a perk, this is one of the times that paying tax and being in the confines of the U.S. would have been O.K. with me.
Paying Taxes on Earned Income Can Be Confusing
The tax laws currently on the books can be complicated and confusing at best. Anyone who is required to pay tax on earned income is advised to seek assistance from a tax professional with any questions or concerns regarding the taxation of earned income. I don’t pretend to know everything about the tax code; just enough to be dangerous. That’s why I’ve hired a CPA to help with my tax planning and I’m completely comfortable paying him what he’s worth.