It’s been said taxes are one of the two great certainties in life, meaning that no matter what you do, where you work, or where you live, you’ll probably have to pay taxes in some capacity.
But unless you were an accounting major, you probably never took a course on what taxes are or how to understand them. Taxes are a necessary part of earning, saving, and living in this country. But they’re nothing to fear. If you’re new to doing your taxes or simply want to understand them better, let us be your guide.
In this article, we’ll discuss:
- What are taxes
- Common tax terms to know
- A brief history of taxes
- Types of taxes
- Filing options
- How to file your taxes
- What to do with a tax refund
- What happens if you make a mistake on your taxes
- What happens if you don’t pay taxes
- What to do if you can’t afford to pay taxes
- Tips to save money on your taxes
What are Taxes?
Taxes is an umbrella term that actually means quite a lot. Each spring, you file a tax return, which most refer to as “doing your taxes.” But you also have a bit taken out of each paycheck (income and payroll taxes), pay a bit to the local government each year for your house or car (property taxes), and even get hit with a higher price on your bill at a restaurant or store (sales taxes).
The reality is everything is taxed.
And as long as you plan to live, work, and prosper in this country, the government will want a small piece of everything. But the more you seek to understand taxes, the more you realize that if done correctly, it doesn’t need to feel like you’re handing over a massive chunk of money to Uncle Sam each year.
What Do Our Tax Payments Do?
The taxes we pay are used to support government programs. This is because the government is a non-profit entity, which means anything that it does is all supported by US taxpayers. And the amount we pay is roughly split 50/50 between federal and state/local programs.
Federal programs include medicare, social security, defense, veterans affairs, and social programs like food stamps or disabilities. State programs may be specific to local infrastructure, Medicaid, libraries, and social services. Some of the money we pay in also goes towards paying off the massive interest accrual on the federal debt.
So whether you see it or not, the taxes you pay each year are used to fund everyday necessities like the roads we drive on, medical care for the elderly, and support programs for our veterans.
How Can I Help Change Taxes?
It’s no secret that taxes in this country are downright complicated. The Tax Foundation estimates the current tax code at around 70,000 pages. And new changes and revisions are being made every single day.
Changes to tax law happen on the federal and state level. And what changes take place depends on the representatives we elect to office. That means the best way to initiate change in the tax code is to contact elected officials, participate in local government, and be smart about who you vote for.
While we may not be able to directly rewrite the tax code ourselves, we indirectly have a say by who we put in office.
Does Everyone Need to File Taxes?
Whether or not you need to file taxes depends on a combination of your filing status, your age, whether you can be claimed as a dependent, and your amount of earned income during the tax year. It’s worth noting that even if you’re not legally required to file taxes, it may result in a refund. So the slight hassle of completing a tax return could be financially beneficial.
If you’re not sure whether or not you should file, the IRS offers an interactive tax assistant online tool to help you decide. This tool will tell you whether or not filing is a legal requirement and also whether or not you have the opportunity to get a refund.
General Tax Terms to Know
Before we dive in, these are some commonly used terms that tax filers need to get familiar with.
- Internal Revenue Service (IRS): This is the bureau of government under the Department of the Treasury responsible for collecting taxes. Their mission is to help taxpayers understand their responsibilities and to fairly enforce the tax laws.
- Filing Status: Everyone who files taxes must choose a filing status based on their unique marital situation. The 5 filing statuses are single, head of household, married filing separately, married filing jointly, and qualifying widow(er) with dependents. These statuses each have specific eligibility requirements. For example, the head of household status requires that you contribute more than half of the cost of keeping up a home. If you’re unsure of the most applicable filing status, you can use the IRS filing status tool to figure it out.
- Taxable Income: Taxable income encompasses everything you earn that the government can tax. That includes wages, bonuses, tips, and earnings from assets or investments. Come tax time, you need to pull together and report all taxable income or risk a potential IRS audit.
- Audit: An audit happens when the IRS takes a more critical look at your tax returns. If they believe something doesn’t quite line up with your income or deductions, they could issue an audit. Most audits will occur via mail, with the IRS sending a letter requesting additional information. But if things get more serious, you may be asked to come into an IRS office, or a field agent may be sent to your home to further discuss any tax issues that arise.
- Deduction: Deductions are ways to lower your taxable income, and they range from charitable contributions to qualifying business expenses. There are two main types of deductions: standard or itemized.
- Standard Tax Deduction: Most people with more straightforward financial situations will take the standard deduction. That means when you do your taxes, you’ll take a lump sum amount and deduct it from your taxable income. For 2021, the standard deductions are $12,550 for single filers or married couples filing separately, $18,800 for the head of household, and $25,100 for married couples filing jointly.
- Itemized Tax Deductions: Itemizing means you’ll track individual items to deduct. People generally choose to itemize when deductions amount to a more significant sum than the standard deduction. Itemized deductions may include property taxes, mortgage interest, charitable contributions, or expenses for a small business.
- Tax Credit: While deductions lower your taxable income, tax credits decrease your tax burden if you owe money. You can subtract the amount of a tax credit dollar for dollar, and some types of tax credits even make you eligible for a refund. For example, if you owe $500 in taxes but are eligible for a tax credit of $500, your tax liability would drop to $0, and you wouldn’t owe anything. Some common tax credits are the earned income tax credit, lifetime learning credit, and child and dependent care credit.
- Withholding: When you work a full-time job, your employer is required to send some money to the government before you get your paycheck. But you do have a say in the amount of money to withhold from each paycheck when you fill out IRS form W-4. The IRS’ Tax Withholding Estimator can help you understand the most appropriate withholding for your unique working situation. Appropriate withholding means you should come out about even on taxes and not have a huge refund or a large tax bill.
- Capital Gains: Capital gains are the profits created through the sale of an asset. Capital gains taxes can be long-term or short-term based on how long you held the asset before the sale. For example, if you bought a house, lived in it for less than a year, and sold it at a profit, the difference between the purchase price and the sale price would be taxed as short-term capital gains.
- Adjusted Gross Income (AGI): Your gross income is the amount of income you made (or profits for a business). The adjusted piece refers to adjustments you can make to lower your gross income. Eligible adjustments may include things like contributions to certain types of retirement accounts, contributions to Health Savings Accounts, or the cost of medical coverage for someone who is self-employed. Your AGI minus the standard or itemized deduction equals your taxable income.
- Tax Exempt: Exemption means you have the right to exclude a portion (or sometimes all) of your income from being taxed. This may be the case for individuals who meet specific criteria, like making below a certain dollar amount. Some organizations like non-profits and churches also have tax-exempt status.
- Refund: If you file your tax returns and you’ve paid in more than you owed throughout the year, you’ll be eligible for a refund. While it may be exciting to receive a refund, it’s actually been your money all along. You just inadvertently gave the government an interest-free loan. If you get a sizable refund, it might be wise to reassess your withholding to see if you could be bringing home more per paycheck instead.
- Liability: If you file your tax returns and owe more than you paid throughout the year, you’ll face a tax liability. That means there’s a sum of money you owe to the government to bridge the gap between what you paid and your overall tax burden.
- Tax Extension: If you don’t have time to file your taxes, you can file an official IRS request for a 6-month extension for any reason. But you’ll still need to pay the amount owed or face interest or other negative implications of non-payment, as we’ll discuss below.
A Brief History of Taxes in the US
It might seem a little crazy to think, but income taxes in the United States are only a little over 100 years old. But that doesn’t mean taxes were a new idea altogether. For all of history, there are records of people paying taxes in the form of livestock or agriculture, and the concept itself has been traced back to 3000 BC.
In US history, taxes came and went several times as ways to help fund various war efforts. Notably, in 1861 Lincoln imposed an income tax to help fund the Civil War. But that tax was repealed a decade later, with no “official” income taxes being signed into law until the early 1900s.
In 1913, states ratified the 16th amendment, which gave the government the power to collect taxes on income. Since then, taxes have turned into the primary source of government funding, with about 86% of all federal government revenue coming in from a combination of income and payroll taxes.
Individual vs. Business Taxes
While each individual is responsible for filing income tax returns, businesses are accountable for filing taxes on their earnings as well. Tax brackets for corporations increase as company earnings rise, with higher-earning companies paying more in taxes.
Business taxes are on a different schedule than personal taxes. Instead of an April 15th filing deadline, companies are faced with the payment of quarterly taxes, monthly payroll taxes, and annual taxes. For this reason, many businesses choose to have their taxes handled by professionals.
Types of Taxes and Associated Forms
According to the Tax Foundation, an independent tax policy non-profit, taxes can be lumped into three main categories: taxes on what you earn (income), buy (sales), and own (property). Within each of these categories, there are multiple kinds of taxes.
Taxes on What You Earn
It’s likely your employer withholds money for income and payroll taxes from each paycheck if you’re a full-time employee. The idea of withholding money at the employer exists so the government can be sure that they’ll receive their money.
Because let’s face it, once you take your money home, it’s way harder to fork it over. But if it’s taken directly from your paycheck, you may not feel it as much.
When you start a new job, you fill out a series of forms that provide your employer with information, like where to send your direct deposit, benefit elections, and your eligibility to work (Form I-9). But you’ll also populate a necessary tax form, the W-4, which instructs your employer how much income tax to withhold from each paycheck. You get to decide withholding because income tax is 100% paid by the employee, unlike payroll tax which is a shared expense between employer and employee.
Your tax withholding may change based on how many jobs you have and the number of dependents you support. Choosing the proper withholding helps ensure you won’t owe a massive tax bill at the end of the year or be giving the government a free loan while living on a much smaller paycheck. If you’re not sure how to fill out your W-4, your employer should be able to help, or you can use the IRS’ online withholding calculator.
Ultimately, how much income tax you pay will vary based on your household income, filing status, retirement account contributions, withholding allowances from form W-4, and location. And income tax is progressive, meaning the percentage of tax you pay increases at set intervals as your overall earnings, or taxable income, increases. Simply put, the more you make, the more you pay.
And what you pay in income taxes support government programs, including defense, veterans affairs, law enforcement, social programs, and paying toward interest on the national debt.
The table below outlines the 2021 federal income tax brackets for single filers and those who are married filing jointly. Other tax brackets can be viewed on the IRS website.
|Tax Rate||Income for Single filers||Income for Married, filing jointly|
|10%||$9,950 or less||$19,900 or less|
|12%||$9,951 to $40,525||$19,900 to $81,050|
|22%||$40,526 to $86,375||$81,051 to $172,750|
|24%||$86,376 to $164,925||$172,751 to $329,850|
|32%||$164,926 to $209,42||$329,851 to $418,850|
|35%||$209,426 to $523,600||$418,851 to $628,300|
|37%||$523,601 and up||$628,301 and up|
With progressive taxation, a single filer who makes $50,000 in 2021 falls into the 22% tax bracket. But that doesn’t mean the entire $50,000 is taxed at 22%.
The first $9,950 is taxed at 10%, income up to $40,525 is taxed at 12% and income between $40,526 and $50,000 is taxed at 22%. Plus, when you factor in deductions, someone making $50,000 may not end up owing anything in the 22% tax range.
If you’re interested in estimating your income taxes, some online calculators can help you see whether you may get a refund or owe money come April.
For those who are self-employed, you’ll be responsible for withholding money from your earnings to pay taxes. Because just like a major corporation, you’ll be responsible for covering the employer portion of payroll taxes plus the employee portion of both income and payroll taxes.
Self-employed individuals can pay estimated quarterly taxes or pay a lump sum plus a minor penalty at the end of the year.
Payroll taxes differ from income taxes in that they’re paid by the employer and the employee and are taxed at a flat rate. Both you and your employer will pay a flat 7.65% of your gross wages in payroll taxes.
Payroll taxes are solely used to support social security and medicare programs (which is why you may see a line item that says so on your paystub). These taxes are referred to as Federal Insurance Contributions Act (FICA) taxes and are mandatory for all US employees and employers.
Taxes on What You Buy
Sales taxes vary by state and will increase or decrease based on the category of product. For example, if you go out to dinner in South Carolina, you’ll pay the state’s 6% sales tax on food and also need to pony up an extra 5% on any alcoholic beverages.
Sales taxes are generally paid at the point of sale. So when tax season rolls around, you won’t need to pay anything additional. Where sales taxes factor in is when it comes to deductions. You can generally take either an income tax deduction (standard or itemized) or a sales tax deduction.
In states with no income tax or in a year where you made many big purchases and paid a lot in sales tax, it might make sense to use the sales tax deduction. (But keep in mind you’ll want to be meticulous about record-keeping to know how much you paid!)
Come tax season, you’ll want to assess your income and purchases to decide which deduction is larger. When in doubt, always consult a tax professional.
Taxes on What You Own
When you own property like a car, home, or boat, you will be required to pay annual property taxes to your local government. For example, if you own real estate, you’ll be assessed real estate property taxes that the local government typically uses for area improvements like education or highway repairs.
The amount you owe is based on the value of your property. So a home that’s assessed at $400,000 and a home that’s assessed at $150,000 aren’t going to pay the same amount of taxes. You can use an online calculator to estimate property taxes in your area using your location and assessed property value.
The nice thing about property taxes is that you can deduct them from your federal income taxes if you itemize.
Capital Gains Taxes
When you own investments or other assets, you may need to pay short-term or long-term capital gains depending on how long you hold the investment before you sell it. Capital gains may result from the sale of bonds, stocks, or real estate. Anytime you sell an asset for more than you bought it for, there are capital gains. If you sold an asset at a loss, you might be eligible to report it as a capital loss.
No matter how small, all capital gains should be considered as part of your taxable income. For the most part, short-term capital gains for assets held for less than a year will be taxed at your regular tax rate, which is higher than long-term capital gains for assets held for more than a year.
Three Options for Filing Your Taxes
There are several ways to file your taxes. And which option you choose depends on how comfortable you are with doing taxes yourself. There are three main options:
- Paper forms: While primarily replaced by online platforms, you can still get a good old-fashioned paper tax form directly from the IRS or your local post office. When doing taxes by hand, it’s essential to double-check entries and make sure the forms are legible.
- Online self-service platform: Sites like TurboTax and H&R Block offer online tax tools that will prompt you with questions and guide you through the process step by step. They often also offer access to a tax professional for a small fee. Most of these sites will allow you to file your federal tax return for free but may charge a nominal fee to file state returns.
- Tax professional: If you believe taxes are best left to the experts, plenty of tax preparers are willing to take on the task for a small fee. Depending on the complexity of your taxes, you could expect to pay up to several hundred dollars for professional tax preparation.
How to File Your Taxes
There are two primary tax returns you’ll need to file, federal and state. The federal tax return is the same for everyone. But each state will have specific laws surrounding taxation, and you’ll need to file based on your state of residency for the specific tax year for which you’re filing.
The federal tax return must be filed and accepted before you can file with your state. But the nice thing is, most tax programs will quickly transfer information from your federal return to make it simpler to fill out your state return.
Follow the steps below when you’re ready to get started filing your tax returns.
Step 1: Gather your tax forms
Based on the types of income and investments you have, you’ll receive several tax forms. And while you may receive some shortly after the first of the year, you could be waiting a month or two before all entities have provided the necessary forms.
Some of the most common tax forms you may receive are:
- W-2: If you worked full or part-time and your employer withheld taxes (aka you were not working as an independent contractor), you’ll receive a W-2 that outlines your earnings and the amount of income and payroll tax withheld.
- 1099-DIV: You’ll receive a 1099-DIV to track any dividends or earnings from investment accounts throughout the year. Banks and investment firms are legally required to provide this document by January 31st.
- 1099-NEC: You may receive a 1099-NEC (non-employee compensation) form if you earned over $600 working for a business as an independent contractor.
- 1099-INT: This form outlines interest income earned from a savings account if it’s more than $10 over the year. Technically, even if you don’t receive a form, you should report all interest income, even if it’s less than $10.
- 1098: For those who paid more than $600 in mortgage interest, your lender should send you a form 1098 as that expense is tax-deductible.
- 1098-E: If you paid interest on federal student loans, you’d receive a form 1098-E to write off the loan interest.
Keep in mind that while you may use these forms to populate your tax returns, you won’t necessarily need to send them to the IRS. Simply tracking the information on your return is sufficient since forms like 1099 are also submitted to the IRS by the entity that sends them to you.
Step 2: Choose a filing status
Filing status is based on if you’re married and whether or not you’ve contributed to household expenses. It’s critical to choose the proper filing status as it decides which tax bracket you’ll be placed in and which standard deduction amount you can take.
For example, suppose you qualify as both single and head of household. In that case, you’ll want to choose the head of household option because the standard deduction is higher, and it will ultimately result in lowering your taxable income. It’s wise to review options and choose the one that will save you the most money.
If you’re unsure which filing status to choose, the IRS offers a tool to help.
Step 3: Assess deductions and credits
There are numerous deductions and credits available that help to lower your taxable income. Many electronic filing services simplify this step by asking questions to determine your eligibility.
Be sure to look through common deductions and credits and those specific to your unique employment and income. And always consult a tax professional if you think you could be saving more.
Step 4: Fill out your tax returns
Depending on which method you choose, paper forms, electronic filing service, or tax professional, you’ll follow the necessary steps to complete your taxes. All information you’ll need should be available on the tax forms you gathered in step 1. Once all sections are completed and checked for errors, you’re ready to file.
Step 5: Filing your taxes
Filing your taxes simply means submitting them to the IRS. Filing can be done via mail or electronically through a tax program. The most crucial part of filing your taxes is to be sure to e-file or have them postmarked by tax day, typically April 15th. If you can’t meet the tax day filing requirement, it’s wise to request an extension.
Step 6: Make a payment or receive a refund
After your taxes are completed, you’ll either need to issue a payment immediately or wait several weeks to receive your refund. You can choose to receive your refund via check or have it sent via direct deposit to your checking account.
What Should I Do With a Tax Refund?
While a tax refund may seem like a sudden windfall, there are a few next steps to consider after receiving a large refund.
- Adjust your withholding: If you received a significant refund, assess your tax withholding and see if you need to make a change to receive more in each paycheck instead. Remember that your tax refund is essentially an interest-free government loan and money that could have been in your pocket all year long.
- Build emergency savings: If you don’t yet have an emergency fund, a tax refund is an excellent opportunity to start one. Building a financial buffer can help to support the next time life throws you a financial curveball.
- Pay off debt: If you have lingering short or long-term debt, a tax refund is a great way to knock it out and move on to living debt-free.
- Treat yourself: If your financial house is pretty much in order, take a bit of money to treat yourself to something meaningful. There’s no harm in having a good time, and an unexpected payday is an appropriate way to do it!
What Happens if I Make a Mistake on My Taxes?
Mistakes happen. But if you notice a mistake on your taxes, it’s critical to file an amended return with the correct information as soon as possible.
If the mistake is noted by the IRS, they may go ahead and adjust the error or notify you to submit an amended return. Either way, the IRS issues a letter outlining the mistake and the steps to correct it. They WILL NOT call you regarding an issue, so if you receive a phone call that states there’s an error in your taxes, and that you still owe money, it’s most likely a scam.
The worst outcome of a mistake on taxes is that it could increase your chances of being audited by the IRS. An IRS audit happens when there’s a discrepancy between what you reported as income and what the IRS believes you actually owe.
Many audits are resolved without issue. But the most important thing to know is that you’ll need to respond to the IRS timely and be honest about any mistakes made.
What Happens if I Don’t Pay My Taxes?
Uncle Sam generally frowns upon those who don’t plan to pay their taxes. And you best believe there will be consequences. If you owe the government money and fail to file your return, you might be faced with:
- Penalties and interest: The longer you go without paying what’s due, the amount you owe will increase due to penalties and interest charges. You’ll start receiving failure-to-file penalties, which are a percentage of what you owe. These failure-to-file penalties are enforced on the federal level and may be implemented by states and local governments, too.
- Liens: The government can put liens on your property that would require you to pay a fine to sell the property.
- Seizure of assets: To get the taxes the government is owed, they could resort to seizing your property.
- Wage garnishment: The government reserves the right to take funds directly from your paycheck if you continue to evade paying taxes.
- Jail time: While extremely rare, you could potentially get locked up if you’re in such deep tax waters that the IRS is filing criminal charges. Jail time is typically reserved for fraudsters and tax evaders. The IRS isn’t looking to put average Joe in jail for not being able to pay taxes due.
It’s also important to note that there is a 10-year statute of limitations as it applies to unpaid taxes. That means after 10 years, the IRS will no longer attempt to collect on an unpaid balance due except in certain circumstances.
What Should I Do if I Can’t Pay My Taxes?
If you’re faced with a tax bill you can’t afford to pay, you might think the best option is to not file at all. But as outlined above, not filing can land you in financial and legal trouble.
If the financial burden of paying your taxes is too much, it’s best to:
- Contact the IRS: The most critical thing to do when you realize you can’t afford to pay taxes is to contact the IRS to open up a discussion about the next steps. Avoiding the conversation does you no favors.
- Set up a payment plan: The IRS may be able to set you up on a payment plan, referred to as an installment agreement, that allows you to make smaller payments over time instead of a lump sum. It’s easy to apply for a payment plan online, and you’ll be instantly notified of approval.
- Request an offer in compromise: If you cannot pay the amount owed and don’t plan to be able to in the future, the IRS may be willing to compromise to recoup some of their tax loss. Depending on your income, assets, and expenses, the IRS may be willing to work with you towards a lump sum or periodic payment plan. You can check eligibility and submit an application online.
Ways to Save Money on Taxes
There are several ways to reduce your overall tax burden and ultimately save money on taxes.
Use retirement accounts
Pre-tax contributions to certain employer-sponsored retirement accounts, like a 401(k), 457, or 403(b), can help lower your taxable income. That’s because tax-deferred retirement contributions are removed before your employer takes out income and payroll taxes. Therefore, it’s not considered a part of your taxable income. You’ll end up paying taxes on those contributions when you remove them from the account down the road in retirement.
An individual IRA using pre-tax contributions is also beneficial in the same way. Instead of the employer removing funds before assessing taxes, you’ll simply report any traditional IRA contributions on your taxes as a deduction to lower your taxable income.
Unfortunately, those benefits don’t extend to a Roth IRA as that retirement investment uses after-tax dollars and already has the benefit of tax-free growth.
Leverage eligible deductions
Deductions help to reduce your overall taxable income. And which ones you take depends on if you plan to take the standard deduction or itemize. If you itemize, some of the available deductions include:
- Charitable contributions
- Health insurance premiums
- Child care expenses
- Mortgage interest
- Gambling losses
- Retirement contributions
- Self-employment expenses
If you’re not sure whether the standard deduction or itemized will be more financially beneficial, you can do your returns both ways or have a professional do the same to confirm.
Review tax credits
Tax credits reduce the amount of your final tax bill instead of your taxable income. Credits may reduce what you owe to a smaller amount or even help get you a refund when you previously may have needed to pay money.
You can find lists of available tax credits online, and many online tax filing tools will ask questions to determine your eligibility.
Especially if you plan to itemize deductions, you’ll want to be sure to keep meticulous track of everything you paid for and have receipts to back it up. Even though the odds of an audit are slim, if you claim extravagant deductions, the IRS may come back and ask you to verify via receipts.
If you own a small business, it can pay to keep folders for personal and business expenses. Even keeping a running expense log or spreadsheet throughout the year can help make sure you don’t miss anything.
Get help from an expert if needed
If you’re not sure what deductions you’re eligible to take or have an overly complicated financial situation, paying a professional to do your taxes can actually end up saving you money.
The Bottom Line
While you’ll never be able to fully get away from paying taxes, being informed about how they work can help you find ways to save money over time. To make filing your taxes simpler, remember to:
- Check to see if you need to file taxes based on your age, income, dependent status, and filing status
- Choose appropriate withholding to make sure you don’t over or underpay throughout the year
- Review eligible deductions and tax credits to be sure you’re saving the most money possible
- File your annual tax returns timely and correctly to avoid a penalty or an audit
- Reach out to the IRS for assistance if you notice a mistake, or you find that you can’t pay what you owe
- Consider seeking help from a trusted tax professional
We hope this information means you’ll be much wiser and better prepared to handle taxes when the next tax season rolls around.