By having income taxes withheld from your paycheck each pay period, you’re really prepaying an estimate of the taxes you’ll owe for the year. You settle up your bill with Uncle Sam and any states you worked in when you prepare your tax return after the end of the year.
The amount you have withheld is calculated based on a number of factors such as your filing status (married, head of household, or single), the number of jobs you have held, and the number of withholding allowances you claim on the Form W-4 you file with your employer. You should file a new W-4 with your employer if you:
You can use the IRS online withholding calculator (www.irs.gov) to walk you through the W-4. And if circumstances change during the year, or you realize you’re having too much or too little withheld, you can always fill out a new form and change your withholding.
Withhold or Save?
It never makes good financial sense to have more income taxes withheld than you know you’re going to owe. Instead of giving the government a big interest-free loan all year, you could use that extra money to pay down debt faster, or have a fixed amount automatically deducted from your paycheck and deposited in a savings account.
Your income is taxed based on seven taxable income brackets (sort of like buckets), ranging from 10 percent to 37 percent. The higher your income, the more tax brackets you’ll cross, with the income that falls within each bracket being taxed at the rate for that bracket. You can find the most current tax brackets on the IRS website at www.irs.gov.
These brackets work the same for everyone. The first bucket’s worth of income (the limits are based on your filing status) gets taxed at the lowest rate. Income that spills over from that bucket gets taxed at the next highest rate, up to that bracket’s limit, until you hit the top bracket and all additional income gets taxed at the highest rate. The last bucket your income falls into tells you your marginal rate (the tax rate you’ll pay on your next dollar of income).
Your effective tax rate (or average tax rate) is the tax rate you actually pay on your total taxable income (after deductions). To calculate your effective federal tax rate, divide your total federal income tax bill (not the amount that was taken out of your paycheck) for the year by your total income. Your effective tax rate lets you know how much taxes (by percent) you’re really paying with respect to your total income.
When it comes to taking tax deductions, you have two choices. You can take the standard deduction, which is a fixed dollar amount that you deduct from your taxable income, or you can itemize deductions. For 2020 the standard deductions based on filing status are $12,400 if you’re filing single, $24,800 for married filing jointly, and $18,650 for head of household.
If your actual allowable deductions total more than the standard deduction, you’ll save money by itemizing. To see if you qualify, use a copy of Schedule A from Form 1040 to list the amounts of each of the deductions that apply to you, such as home mortgage interest, real estate taxes, state income taxes, and charitable donations. If the total is more than the standard deduction, itemizing is worth the extra work.
For millions of people, filing tax returns brings up fear and anxiety. They’re worried about making mistakes and getting audited. They’re afraid they’ll owe money and not be able to pay. The whole process seems overwhelming. But with tax apps and software, filing your income taxes (unless you have a complicated situation) can be a breeze.
There are two versions of the US Individual Income Tax Return Form 1040: the standard form and a form designed for seniors, 1040-SR.
Most Americans will use Form 1040, also called the regular or standard form. You’ll use it to calculate your total tax bill and find out whether you overpaid or underpaid during the year. If you overpaid, you’ll get a refund; if you underpaid, you’ll owe more money. You figure your tax bill by reporting all of your income and claiming any tax deductions and credits you’re eligible to take.
Form 1040-SR makes tax filing simpler for seniors age sixty-five and older. These forms use bigger type for easier reading, and simplify the layout of the form. There is also a standard deduction table right on the form, so seniors can get the full deductions they’re entitled to.
You can find either of these forms and their related instructions online at www.irs.gov.
Doing your own taxes is easy using tax software (either online or on your computer) or apps such as TurboTax, TaxAct Express, or H&R Block mobile tax app. This type of software handles both simple and complex returns with ease, and most returns can be completed and e-filed within a couple of hours. Most of these programs walk you through an interview process by asking you questions (which you can skip if you’re familiar with the forms), do all the calculations, produce your finished tax return, and e-file it for you.
If you don’t want to use tax software, you can still prepare your tax returns with pen and paper. However, if you file electronically, you can get your money more quickly, especially if you have your refund automatically deposited to your bank account. If you file a paper return, expect at least four weeks to get your refund, and even longer if you file later in the season.
Approximately half of Americans use a tax preparation service of some type. While it pays to use expert help if you have a complex tax situation, you can save yourself hundreds of dollars (possibly thousands if your financial situation is complex) by preparing your own return. There are times when it’s almost certainly a good idea to seek professional tax assistance—for instance, if you:
The qualifications of tax preparers vary immensely, and so do their fees. Certified public accountants (CPAs), tax attorneys, and enrolled agents (certified by the Treasury Department) are the only professionals who can represent you in an audit if that ever becomes necessary.
If you bring your tax information to five different preparers, you may end up with five different tax bills. To find a reputable, experienced tax pro, start by asking friends, family, coworkers, and other professionals for recommendations. If you can’t come up with a recommendation this way, try contacting the local chapter of a professional association such as the American Institute of Certified Public Accountants (AICPA). Once you’ve identified someone you’d like to use, talk to her on the phone and ask about her qualifications, background, and fees. Find out whether she works full- or part-time doing tax consulting, how many years of experience she has, and whether she participates in continuing professional education. This last point is important because tax preparers need to keep up with yearly changes in tax laws. When you’ve made a decision, make an appointment well in advance of the filing deadline.
Think about how much of your income goes toward taxes. If you’re in the higher tax brackets, you may be handing nearly half of every dollar you earn to Uncle Sam, but there are things you can do to keep more of your hard-earned money.
Homeownership As a Tax Shelter
Owning a home may also help you reduce your income tax bill. Not only may you be able to deduct your mortgage interest and property taxes (up to $10,000) from your taxable income, you also get to keep up to $250,000 ($500,000 for married couples) of profit when you sell without paying any taxes on the gain, as long as you’ve lived in the house for at least two of the five years leading up to the sale.
Another way to reduce taxes is to be sure you take all the credits and other tax reductions you’re entitled to, such as the child credit, education credits, head of household status, or earned-income tax credit.
Bunching deductions is a time-honored approach to cutting taxes. It requires an awareness of what your tax situation is before the end of the year. If you’re close to being able to itemize, bunching your deductions may put you over the threshold. Bunching is a strategy that involves timing your payments of deductible expenses by pushing as many deductions as possible into one year. When you bunch, you fatten up your deductions for one year and slim them down the next year, or vice versa. If you’re close to having enough medical expenses to meet the 10 percent of income requirement, and there’s a medical procedure you’re planning (anything from dental surgery to a medical checkup), having it before the end of the year could put you over the limit and reduce your taxes.
Refunds
Most people have too much tax withheld from their paychecks and get a refund at the end of the year. In 2018, the average federal tax refund was $2,781. That’s roughly $230 per month that could have paid down debt or been deposited into a savings account.
You should keep detailed and organized records as though you expect to be audited. Then if you ever have to prove your income or deductions you won’t be scrambling to find receipts and other documents. Without that backup, you could end up owing more taxes plus IRS penalties and interest.
Hang on to any documents that identify your sources of income (W-2s, 1099s), help determine the value of assets (brokerage and mutual fund statements), and prove your deductions (receipts or invoices and canceled checks, property tax statements, mortgage interest statements, and proof of any business expenses if you file Schedule C). Checks alone may not prove the deductibility of an expense. The best proof is an itemized invoice accompanied by a canceled check proving that you paid it.
Keep your tax records in a separate file for each year. The IRS recommends keeping records for three years after the related tax return was filed, or two years after the date you paid a tax bill. Most financial professionals recommend keeping copies of your income tax returns, retirement account statements, home purchase or sale documents, and stock or other investment documents for six to ten years. You can also scan your documents, and the IRS will accept those if needed.