Taxes 101 - Basic Things You Should Know

Hey, what's up everyone and welcome to the School of Personal Finance. So it's that time of year again, tax time. And since I spent the last week going over my own tax stuff and putting together a package to give to my accountant, I thought it would be a good idea to go over basic tax terminology and concepts. We're looking at like a W-2 form and a 1040 and talking about tax deductions versus tax credits and itemizing versus the standard deduction and all things that really you should know so you can make better decisions and ultimately pay less in income taxes. All right, let's get to it. All right, so before I get started, just my little disclosure, I am not a CPA. Do not take anything I say as tax advice. Talk to your own accountant before implementing anything I talk about in this video. So you know it's tax time when you start getting all the stuff in the mail, right? You get your year-end statements, you get your W-2 stuff, you get 1099 forms from banks, from brokerage accounts, you get your mortgage interest statements and you start putting it all together, getting it ready. Hopefully you have an accountant that you use to do your taxes and you send it off to your accountant or you do it yourself through TurboTax if you have a pretty simple situation. But I wanted to start out by taking a look at W-2 forms just so you understand exactly what's going on when you receive that W-2 and you know what you're going to be inputting or gauging what you're going to be paying on taxes for the year. All right, so let's take a look at a W-2 that I just found online as a quick example. So now looking at this W-2, it's going to have all your basic info, your social security number, your employer's information. If we look at box one, this is your wages. So now the number in here is what is going to be reported on your tax form 1040, which I'll show you in a few minutes. But in this example, it is $47,000. So that is their wages. And then if we look at box two, this is how much federal income tax was withheld out of their paychecks. We could see that it was 10%, $4,700. Now, is that enough? We're not going to know until we're actually done doing your tax return. But if you find yourself every year owing taxes, then what you could do is you could have extra amounts withheld using a W-4 form, which is another form that you file with your employer to let them know how much withholding they should take from your paychecks. But if this $4,700 that you're having withheld ends up being short, then a way to adjust that is to have more withheld throughout the year that gets sent to the IRS. So at tax time, you do not owe them money and vice versa. If you end up getting a big refund every year, then you could have less withheld so that your paychecks are bigger every two weeks or how often you get paid. But what's going on with this is that each time you get paid, your employer is sending money to the IRS. So you are paying taxes throughout the entire year. And then at tax time, when you file your return, that's when you figure, have I paid too much or have I paid too little? So you either get a refund or you owe money. So now box three, this is the social security wages. So as we can see, this is higher than box number one, the $47,000. And the reason for that, it can be many different reasons. But I'm just going to make the assumption here that it's because this individual, they contributed $3,000 to their 401k plan. So when you make a contribution to your 401k plan or your 403b plan, that money comes right off the top. It's not even reported on your 1040. It reduces your taxable wages, your taxable income right off the bat. So one quick way to save money on taxes every year is to contribute as much as you can into your 401k plan because it doesn't even flow over to your 1040. So in social security, 14.4% of your salary goes to social security. Now you pay half of that and your employer pays half of that. So as we could see in this example, social security wages is $50,000. So 6.2% of that is what has been withheld for social security, that $3,100. And now in social security, you're only responsible up to the wage base, which is $137,700 in 2020. So what that means is once your salary goes above that, you no longer have to contribute into social security. So you might find yourself, if your income is above that, at some point during the year, it's almost like you get a little raise because you don't have to contribute to social security anymore once you get above that wage base. So this is where that $3,100 comes into play. And now your employer is also putting $3,100 in this situation into social security for you. Now, if you're self-employed, this is what we call the self-employment tax. You have to pay both of those. You have to pay the 6.2% for employer contributions and 6.2% of employee contributions. So that's the self-employment tax plus Medicare, which we're going to get to now. So now to fund Medicare, there is 2.9% of your income that goes to Medicare and you are responsible for half of that. So that is 1.45% of your salary. So we could see here on $50,000 Medicare wages, 1.45% of that is that $725 that is sent to fund Medicare. Your employer is responsible for the other half. So they also kick in $725 in this example and send it off to Medicare. Now, Medicare does not have a wage base cap. So no matter how much money you make, you are going to be paying this 1.45% on all of your wages. And then on top of that, if you make over $200,000, then there's an additional 0.09% on top of the 1.45% as an additional Medicare tax for incomes over $200,000. So when you add Social Security and Medicare, that is what's called your FICA tax. And that is the 7.65% that you are responsible for to pay into Social Security and Medicare. And then your employer, they pay the other half of that. And again, if you're self-employed, then you've got to pay the whole shebang. Then you're paying 15.3% of your income to Medicare and Social Security compared to somebody whose employer is paying half, they're only paying 7.65%. So that is where we get the self-employment tax from. Now, if you are self-employed, then you might receive 1099s in the mail for like contract work that you've done or non-employee compensation, where you might have to pay quarterly estimated income taxes because there's no withholding. You don't have an employer that is withholding your taxes and sending it to the IRS every two weeks or whatever. So you have to pay quarterly estimated taxes. All right, so let's go into RightCapital and we'll take a look at an example of a 1040. So if we look right here on line one, $123,500. So this is their W-2 income. So this is what's reported in box one of their W-2. Now, in this example, I have a husband and wife. So these are their salaries. And again, this number is after their 401k contributions. All right, so this is the amount that's reported in box one. And then tax exempt interest, qualified dividends, that would just be on savings accounts and the brokerage accounts that gets reported to them. And then your total income, so $124,267. And then on the line below, we have the adjusted gross income. So the reason that there's a difference here, it just doesn't show it on this 1040, is for adjustments to income. So in this example, it was a deduction for student loan interest. All right, and then the next line item we see here, line eight, this is standard deduction or itemized deduction. Now, in this instance, they are taking the standard deduction. So all that means if you are a married filing joint, you have a standard deduction of $25,100. So you could reduce your adjusted gross income by this $25,100, which means your taxable income would only be $97,686. So anybody qualifies for that. So now if you actually have more deductions in your situation than the standard deduction, more than this $25,100, then it makes sense to itemize your deductions. Now, if we look over here at A, this shows the amount of tax that is due on a taxable income of $97,686. So now remember, we haven't even looked at how much they've actually had withheld from their W-2 yet in this scenario. All we're doing is calculating the tax liability for the year based on their income. So $12,948, that's how much tax they owe as of right now. Now they have two children, so they are going to get $4,000 in the child tax credit. So we see $4,000 brought over here, it gets subtracted from their tax that they owe. So now we are at $8,948 in taxes that they owe. So in this example, if they had $9,000 withheld from their paycheck, then they would get $52 back at tax time. But what if they had $15,000 withheld, then they'd be getting like $6,000 back. What if they only had $6,000 withheld from their paychecks throughout the year, then they would owe $3,000. But this $8,948 or whatever it is, that is the true amount of taxes that they owe. So yes, you could get a refund or you could owe money, but that is just based on how much you actually paid throughout the year, on how much you had withheld throughout the year. What you want to do is you want to reduce the amount of taxes that you owe. That is the real number. And it's best to try to match your withholdings to be as close to the amount that you actually owe throughout the year. You shouldn't be getting huge refunds or you shouldn't be owing a ton of money. You want to try to get it as close so that it's accurate. Personally, I do like getting a refund back. It's almost like forced savings, but it is better to get the money in your paychecks throughout the year and save it on your own, even though many of us do not actually go ahead and do that. All right, everybody. That is it for this one. Went through a lot of stuff in this video. I hope that you found it helpful, especially here at Tax Time. Please hit that like button if you enjoyed this one. Hit that subscribe button if you have not subscribed to the channel yet. Go check out SchoolOfPersonalFinance.com. Join my email list so you're up to date with everything that I'm putting out there. I'll see you again next week. Thanks.