How Do Federal Income Taxes Work? (Part 3 of 3)

Thanks for joining me for the epic conclusion to my 3 part series on taxes. I’m glad that both of you stuck with me on this until the end.

To summarize (and please read the 2 earlier blogs before reading Part 3), Part 1 was about calculating “taxable income”. Part 2 was about taking this taxable income and determining how much money you’re supposed to pay the government to be a citizen of this country. Pretty simple concept, yet it can be intimidating and certainly can be complicated when you get down to the nitty gritty. But hopefully the big picture is a little clearer now.

Tax Refunds

Now I want to try to clear up a common erroneous misconception, which is your tax refund. As you know, each paycheck you get, the government takes out some amount for federal income tax, based on how much you make and how many exemptions you put on your W-4 form. The amount that is taken out for federaltax refund income taxes each pay period has zero affect on how much you actually pay in taxes.

To take it a step further, if you’re getting excited because the IRS wrote you a $5000 check at tax time, all that means is that instead of paying them (through your paycheck withholdings) the $1638 that you actually owe them (from our example above), you actually OVERPAID by paying them $6638 throughout the year. So the government just says, hey, I don’t know why you sent us all this money, but here is your $5000 back, we really only needed the $1638. So in March of 2015 you can get your $5000…OR every month in 2014, you could have given yourself a $417 RAI$E! ($5000/12 months = $416.67 per month) So essentially, your refund is basically the result of you giving the government an interest free loan, instead of you having it in your own pocket or investing it. It’s NOT LIKE WINNING THE LOTTERY to have a huge tax refund check. Some people use their tax refund as a forced savings plan. Getting a refund of $500 or so and putting that towards a weekend getaway or some spring projects is one thing. But if you want to save a few thousand bucks for your next car purchase or for a family vacation or to fund your emergency savings fund…set up an automatic transfer into a savings account! If you don’t want to see it every day or have instant access to it so you don’t accidentally (ha!) spend it…set up something like a Capital One 360 Savings Money Market Account. You can have it transfer on your payday so you won’t be tempted to spend it. So essentially, instead of having it transfer to Uncle Sam where you don’t have access to it until February or March of the next year and earning 0% on it, you transfer it to your own account in which you have access to get your money if you need it and you collect interest on it. (At the time of writing, the interest rates are low, only 0.75%, but the rates are variable and the interest rate in a bank account will never be worse than the 0% that the IRS is offering you to hold onto YOUR money!)

Summary

So in summary, taxes don’t have to be scary or confusing. There are certainly a lot of rules and situations, but I am guessing that most people have never been taught the basics. And understanding the basics can go a long ways in understanding how to adjust your W-4 (so you don’t lock your money up all year at 0% return), what effect children have on your tax liability, how you can factor in tax implications when making decisions about schooling or home improvement projects, and certainly many other advantages.

Believe it or not, I enjoy talking about and learning about taxes. If you have questions or comments or see errors, let me know. I may write a couple more posts about some other tax related items, such as how you can use a 529 college savings plan to reduce your state income tax liability (how does an instant 20% cash back rebate sound?) or how to decide between a Roth IRA (or 401k) and a Traditional IRA (or 401k). Or maybe you’re intrigued by exactly what you can do on your W-4 withholdings to control your tax refund for next year, especially if you’re interested in getting an immediate increase in your next paycheck. LET ME KNOW!

Thank you very much for reading!

-Joel

Advertisements

2 responses to “How Do Federal Income Taxes Work? (Part 3 of 3)

  1. So what do you recommend as far as claiming dependents? Should I claim Dave? Should he claim me? I’m not sure I’m using the right term but whatever is on our w2?

  2. Sorry, Kim, for some reason your comment went to our junk mail. I must have had my “Wildcat Filter” on. Anyway… I assume you’re talking about your W-4 for withholding allowances. The W-2 is what you get from your employers in January to report what you earned, you pretty much just type that into your tax return. UNLESS you’re talking about filing “Married, filing separately” versus “Married, filing jointly”. If you are, we can talk about that more.

    If you’re talking about the W-4 that you give your employer so they know how much to take out of each paycheck for federal income taxes…the answer is “it depends”. There are many calculators out there, including the IRS calculator http://apps.irs.gov/app/withholdingcalculator/, but there are some general tips to help get you closer to what you want (for me, less taken out of each check and a smaller refund). There is also a little deeper way to go to help you understand how it works and you can play with different options to come up with almost exactly what you want. Since I’m a nerd, this is the way I prefer to go. The calculators just give you a withholding number, but they don’t tell you what exactly is going to happen if you change your W-4 to that. I don’t want to be surprised at tax time.

    Anyway, since there have been a couple of questions about withholdings / allowances / who should claim what, I’ll try to focus on getting a new blog out there that hopefully can help.

    Thanks for reading and commenting!

    -Joel

What do you think?

Please log in using one of these methods to post your comment:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s