There are a few things in life that we cannot escape no matter how hard we try, one is death, second is taxes. For ever dollar you make you must pay your fair share to society. Even if you’re self employed uncle Sam will want his fair share of your business. There are many misconceptions about taxes and in order to be financially literate you should understand how they work, especially how to use them to your advantage. The way taxes work in the United States are on a Marginal Tax Bracket system. Higher earners will pay more in taxes in the end, but they will pay the same amount as the lower earner in that bracket. This is because on a Marginal Tax Bracket system both parties are paying 10% taxes on their first $11,000 as of 2023.

Marginal Tax System

Information from irs.gov website,
“

• 35% for incomes over $231,250 ($462,500 for married couples filing jointly);
• 32% for incomes over $182,100 ($364,200 for married couples filing jointly);
• 24% for incomes over $95,375 ($190,750 for married couples filing jointly);
• 22% for incomes over $44,725 ($89,450 for married couples filing jointly);
• 12% for incomes over $11,000 ($22,000 for married couples filing jointly).
   

The lowest rate is 10% for incomes of single individuals with incomes of $11,000 or less ($22,000 for married couples filing jointly).”

One of the biggest misconceptions of taxes is if you move to the next bracket, all your income will be taxed at the next %. This is not the case. For example if you earn $40,000 and your boss offers you a $5,000 raise only $275 will be taxed at 22%.

$11,000 @ 10% = $1,000
$33,725 @ 12% = $4,047
$275 @ 22% = $60.5

Total Federal tax liability = $5,107.5
Keep in mind that this is only Federal taxes and not including state taxes and or other deductions that can be claimed which can vary drastically.

So please, don’t turn down a bonus or a raise just because you’re afraid of taxes.

Standard Deduction Vs. Itemized Deduction

For the year 2023 (filed in 2024) the standard deduction is $13,850 for single filers. This is typically already included when you file your taxes. It reduces your AGI (Adjusted Gross Income) making you pay less in taxes. This is why if you earn less than the standard deduction you don’t pay any taxes.

People usually take the standard deduction because it would actually be more than if they were to itemize every qualifying expense. Some of them are; Property Taxes, Medical Expenses, Charitable Donations, and Gambling Losses. If you do have any of these expenses and they are over $13,850 save your receipts and gather your forms because you’re about to get a bigger tax deduction!

Another misconception is if you donate to charity you can reduce your taxes, although true make sure in advance that you will be taking the Itemized Deduction first. I’m not against donating to charities (we all should be) but don’t donate too much and expect a tax break or be disappointed when you don’t qualify.

Tax Credit Vs. Tax Deduction

A tax credit will lower the amount of taxes you owe by taking it off your final tax bill. While a Tax Deduction reduces your taxable income for example the Standard Deduction. Not all tax credits will not give you money back if you get a refund. Some tax credits that do result in a refund are the Earned Income Tax Credit or the Child Tax Credit if there is a surplus with these credits it will result in a tax refund.

Account Contributions

Contributing to some accounts may reduce what you pay in taxes, as mentioned in previous chapters contributing to your 401(k) will reduce your tax liability with the Savers Credit. Other accounts you can contribute to reduce your tax liability are HSA (Health Savings Account) and even your own IRA contributions can reduce your taxes. Keep in mind that only regular IRA contributions can be deducted not ROTH.

Other Misconceptions

There are many ways to reduce your taxes legally. People seem to also forget that taxes are charged on income and not assets. For example if a millionaire has a company which is his asset that is worth 10M and only pays himself a $50,000 salary he will pay only pay taxes on his $50,000 salary and nothing else. This theoretical millionaire can then take a loan against his assets whenever he wants without actually earning a real income. Don’t shoot the messenger though.

You can read or research more about these topics:

Marginal Tax Rate via Investopedia
Standard Deduction via Investopedia
Tax Credit Vs. Deduction via NerdWallet

Thank you for reading and see you next week,
– Pablo