Taxes are an integral part of personal finance, yet usually the part that people dislike most. While it’s rare that anyone enjoys giving away their hard-earned dollars to the government, a lot of the disdain surrounding taxes stems from a lack of understanding. After all, our tax system is incredibly complicated, but learning more about how it works can make the whole idea of taxes much less scary and confusing.
The term “tax” is a very broad concept; in general, taxes are charges established by a government on income, goods and services in order to help fund various government expenditures. For instance, you may pay a sales tax on goods purchased in your home state, a portion of which is used to maintain local roads and highways.
The tax people are usually most concerned with, however, is income tax — the money taken out of your paycheck before you receive it.
Each year, Americans file taxes in order to report their income and pay additional taxes if necessary, or receive money back in the form of a tax refund if they paid too many taxes throughout the year. Filing taxes ensures you’ve paid your fair share and get back any money you are owed by the government.
When filing taxes, it’s important to know which portion of your earnings is taxable and how you are required to report it. For instance, in addition to your normal hourly wage or salary, you must also pay taxes on things like investment income, inheritance — even lottery winnings — and list it all on the correct tax form with appropriate documentation. Just as importantly, though, you should also understand the different tax write offs you are allowed to claim so you reduce your overall tax liability.
Tax deductions are a type of write-off that reduce the total amount of income you’re expected to pay taxes on. Things like charitable donations, moving and job hunting expenses, as well as child care costs and mortgage interest are all types of tax deductions you may be able to claim if you qualify.
Tax credits are also considered tax write offs that lower the amount you end up paying, or in some cases, increase the amount you are returned each year. Unlike tax deductions, however, which reduce your taxable income, tax credits lower the total amount of taxes owed.
State governments, as well as the federal government, offer tax credits as incentives — for instance, the Cash for Clunkers program provided a credit of up to $4,500 to anyone who traded in an older vehicle for a newer one, in order to encourage taxpayers to drive more fuel-efficient cars.
Gaining a better understanding of how taxes work will allow you to plan your finances throughout the year in a way that ensures you aren’t hit with a huge bill from the IRS in April. Taxes don’t have to be a bad thing; you can use tax credits and deductions to actually earn money back each year — just be sure you’re honest on your tax return!
Getting your taxes ready for April 15th can be a confusing and often time consuming process. Here's everything you need to know to help. Guide to Preparing and Filing Your Taxes.