The Following is a guest post from The Financial Genome Project
Introduction To Taxes
Our financial system is complicated, by design, and it’s only by thoroughly dissecting it can we find the best personal finance tips. My website, the Financial Genome Project, is dedicated to that mission of dissecting the financial system and helping us control our own financial path. One of the key aspects of our entire system is taxes. Here are some tips on the most common taxes we experience every day.
These federal taxes are automatically deducted from our paychecks. Social security is 12.4% of our paycheck; 6.2% paid for by you and 6.2% paid by your employer. Medicare is 2.9% of our paycheck; 1.45% paid for by you and 1.45% paid by your employer. There’s an additional .9% tax for highly-compensated employees, which for a single is $200,000 and married filing jointly $250,000. There’s not much you can do about these taxes.
Federal and State Income Taxes
We owe taxes every year. We’re supposed to pay down that tax by giving the federal and our state taxes each month from our paycheck. When you file your taxes, you get a refund if you gave too much or you owe, if you didn’t provide enough. The government tricks us into believing a large refund is good. This is so the government can get more money upfront, use it, and then give it to us at a later date…without interest.
If you’re struggling to make ends meet or are in debt, this cycle of giving too much money each month and then getting a large sum at the end of the year can, mathematically, keep us from financial independence. Finance charges on credit cards can overwhelm us. Having more money each month can help reduce those finance charges.
Our goal should be to get the least possible refund back at the end of the year, while not owing. If you receive more than a $1,000 refund, you should consider changing the number of dependents on your W-4 through your Finance or Human Resources department. This will give you more money each paycheck to pay bills or save, if you’re unsure by how much, consider using a tax calculator.
If you have kids and receive a larger-than-average refund, then it’s most likely due to the Earned Income Tax Credit. You can get this upfront each month to help pay bills, eliminate debt, or invest by filing for Advanced Earned Income Credit. You can also do this through your Finance or Human Resources department.
Tip: I recommend talking to a tax professional before doing this.
State taxes depend on which state you’re living. Some states have punishing state income taxes, while others have no income tax. Just because a state has no income tax, doesn’t mean it has a better cost of living.
Sometimes states with low state income taxes have higher other taxes. Here’s an article from Bankrate discussing the pros and cons of states with no income tax.
Everyone needs a place to live, right?
Even if you own your house and have no mortgage, you still have to pay property taxes. If you rent an apartment, a house, or any domicile, the property tax is baked into your rent.
Property taxes should be a consideration for where you decide to live. If you want to own several homes, you may want to look at states with lower property taxes.
You have to pay taxes on the money you earn, taxes on your shelter, and you also have to pay taxes on every commodity you purchase through a sales tax. There are only five states without a sales tax).
Sales taxes aren’t as ominous as others taxes because, in some ways, you have control over how much you consume. People with high savings rates and frugal shoppers don’t consume as much, so they pay fewer sales taxes.
Savings and Investment Taxes
Even if you do have a high savings rate, you’ll still be faced with savings and investment taxes.
You get taxed on the interest you earn, dividends that you get paid, and capital gains on nearly any asset (i.e., real estate, mutual funds, cryptocurrencies, commodities, options, stock, bonds, etc.).
Here are some tips on avoiding these types of taxes.
- Traditional vs. Roth retirement accounts
- Traditional – these retirement accounts lower your adjusted gross income (“pre-tax”), your investments grow tax-deferred, and then you are taxed on the distributions when you start to withdraw the money.
- Roth – these retirement accounts don’t impact your adjusted gross income (“after-tax”), your investments grow tax-deferred, and you do not pay taxes on the distributions when you start to withdraw the money.
- For most working-age people, Roth accounts are recommended because, if you invested correctly, you’ll need more tax protection in your retirement years.
- Employer-provided plans –Employers often provide retirement plans called 401(k)s, 403(b)s, or Thrift Savings Plans (TSPs). There are other types as well. Often employers offer both traditional and Roth versions of these retirements plans. You can invest $18,500 of your own money in 2018. For employees over 60, you can contribute an additional $6,000 (a.k.a., “catch up”). Your employer can also match your contributions. The total employer and employee contribution limit is $55,000 in 2018. Typically, you’re confined to only the fund options your employer provides. Sometimes these funds are significant; sometimes they are not.
- Individual Retirement Accounts (IRAs)– IRAs are individual accounts that you can invest $5,500 a year (married can save $11,000) and are available as Traditional or Roth options. You can invest in whatever type of asset you’d like (i.e., mutual funds, stocks, bonds, options). There’s an income limit using your Modified Adjusted Gross Income (MAGI). For single people, the MAGI limit is $135,000, but your contribution limits are reduced starting with a MAGI of $120,000; for married filing jointly it’s $199,000, and limits are reduced at $189,000.
- Healthcare Savings Accounts (HSAs)– HSAs are a mix of health-care insurance and a savings account. Contributions are pre-tax so they reduce your adjusted gross income. HSA contribution limits in 2018 are $3,450 ($6,900 if you’re married).
- HSA's funds are not taxed when used for qualified medical expenses. It can be a huge benefit.
- Additionally, many employers contribute $500-$1,000 annually to HSAs without the employee having to do anything to get it.
- Usually, money above a certain balance can be invested in an index or mutual funds. This allows HAS holders to grow their money tax-deferred.
- You can read more about HSAs at the Win At Life Finance blog
- States manage 529b Child College Plans- 529b college plans. These are savings accounts specifically for college expenses for your kids. The money is after taxes, grows tax-deferred, and you don’t have to pay taxes when you withdraw the money for qualified college expenses.
- Taxable Accounts– If you’ve smartly managed your payroll, federal and state, property, sales, and savings and investment taxes, then you’ll have to maneuver through taxes in taxable accounts. Here are some more tips on how to do that.
- Interest/Income Investments– The interest you earn on interest-generating investments are taxed as income and increase your adjusted gross income, possibly bumping you up into a higher tax bracket. Investments that earn interest like bonds and bond mutual funds should be placed in your IRA.
- Municipal bond funds– A way to get around interest taxes is to invest in municipal bonds funds. The interest you earn on these funds is exempt from federal and state taxes. In this low interest-rate environment, the tax benefit from municipal bond funds gives you a higher yield than standard bond funds.
- Stocks– For stocks that you believe will have slow, steady growth and pay dividends, often referred to as “blue-chip” stocks, I recommend keeping these in taxable accounts.
- Capital gains for long-term investments (1 year or greater) are taxed at a lower rate than short-term investments (less than one year). Dividends are capped at 20%, 15%, and 0% depending on your tax bracket. Dividend taxes are usually way lower than your taxable income.
- Short-term stocks– Trade stocks with explosive growth potential in a short period (i.e., day trading) in your IRA. You’ll avoid paying capital gains taxes.
- Mutual Funds– Put mutual funds in both accounts. Mutual funds can pay dividends, capital gains, and end-of-year distributions. Putting most of your mutual funds in IRAs help simplify filing for taxes. Mutual funds in taxable accounts require filing 1099-Int, 1099-Div, and 1099-B forms. You don’t have to file anything but a 5498 form in your IRA and, if you max out your IRA and qualify, you may receive the Saver’s Credit.
- Practice tax harvesting– You’re allowed to offset capital gains with capital losses. Short-term gains can only offset short-term losses; long-term gains for long-term losses. Many investors hold onto stocks that have dropped significantly because of their pride and the hope of a rebound. It’s better to sell the losses and offset your capital gains. You can’t do this in an IRA since you ’re not taxed, so there is no need to keep extended losses just for your pride.
This is just a quick overview of some tax tips. There are hundreds of taxes we pay in the United States, and many countries have even more. Some we’re keenly aware of, and some are covert. The mission of The Financial Genome Project is to map out our complex financial system—similar to the Human Genome Project. By dissecting our financial system, I believe we can educate and motivate people to take control of their finances. I also think it will give us more accountability of all the external factors, like taxes, that influence every aspect of our lives.
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Michael launched Your Money Geek to make personal finance fun. He has worked in personal finance for over 20 years, helping families reduce taxes, increase their income, and save for retirement. Michael is passionate about personal finance, side hustles, and all things geeky.