Most people end up hiring a CPA or a tax preparer or buying software like H&R Block and TaxAct to file their taxes. You answer a bunch of questions and the preparer somehow puts the answers to those questions on a few sheets of paper. Then you send to the Internal Revenue Service (IRS). Because people don't often learn how to file the paperwork on their own, many have trouble understanding taxes.
As someone who used to prepare taxes, I've had people ask me some strange questions. After years of answering these questions, I've realized there are many misconceptions about how taxes work. Here are a few things people usually have trouble with:
1. Your tax bracket is your tax rate.
I can't tell you how many times I've heard someone say they aren't working any more hours or overtime because it would put them in the next tax bracket.
While earning more money may put you in the next tax bracket, it doesn't mean all of your income will be taxed at a higher rate.
The U.S. system is called a "marginal tax system." This means that you're taxed on your income in stages. For this example, the tax brackets are as follows:
Taxable Income -- Tax Rate
- $0 to $15,000 -- 10 percent
- $15,001 to $30,000 -- 12 percent
- $30,001 to $100,000 -- 22 percent
Using theoretical numbers, if you had taxable income of $30,000 last year, you would pay 10 percent on the first $15,000 and 15 percent on the 15,001st dollar through the 30,000th dollar. If you earned $30,001, you'd pay only 25 percent tax on that one dollar over $30,000! You wouldn't pay 25 percent in taxes on all $30,001.
2. Itemized deductions save everyone a ton of money.
For some reason, people seem to think that itemizing deductions means that you're saving a lot of money on your taxes. And this may be true in some cases. But many who itemize deductions aren't saving nearly as much money as they think they are.
When you take itemized deductions on your tax return, you no longer get the standard deduction.
If your itemized deductions don't exceed your standard deduction by a lot, you won't save much in taxes.
All that you're saving is the difference between your standard deduction and the total of your itemized deductions. Plus, a deduction reduces only your taxable income -- not your actual tax due. So if you're in the 22-percent tax bracket, each dollar of deduction saves you only 22 cents in taxes paid.
3. You shouldn't pay off loans that have tax-deductible interest.
I've heard several people argue that you shouldn't pay off student loans or mortgages early because the interest is tax-deductible. But while there could be other legitimate arguments for not paying off these types of loans quickly, tax deductibility isn't one of them.
As discussed above, a tax deduction lowers only your taxable income, not your tax due. So for every dollar in interest you pay, you save just a small portion. It usually comes out to 22 cents or less per dollar of interest you pay. While paying 78 cents is better than paying $1, paying nothing is the best in my book. Paying off your loan saves you 100 percent of the interest you were paying.
4. You pay more taxes on bonuses.
Bonuses are a great way companies reward their employees. Unfortunately, the IRS has special rules for how taxes are withheld on bonuses. Most companies opt to take the easy route and simply withhold 22 percent of the bonus for federal income-tax purposes.
Some people think this means they're paying more in taxes on their bonuses because their usual federal tax withholding from their paychecks is much less than 22 percent. The key difference is that 22 percent is withheld, not actually paid in taxes. While more money is withheld from your bonus, the actual tax you owe is calculated when you file your tax return.
You then apply the money that was withheld or paid in estimated tax payments to calculate whether you receive a refund or owe money at tax time. If more money was withheld than you owed, you'll get a refund. Some may end up getting back part of the money withheld from a bonus in the form of a tax refund at tax time, assuming enough money was withheld throughout the year to cover tax liability for other income.
Armed with this new information, you can help spread awareness and understanding of how taxes work.