Taxes 101

Ugh. Taxes. Even saying the word just makes you want to fall asleep. Taxes may seem like the most complicated, boring thing you could ever think about. But the truth is, they are extremely important and upcoming in our lives. Being a teen, understanding taxes can be complicated and difficult to do, especially without a simple explanation. This can cause concerns and uncertainty about the near future. In this article, we will break down the basics of taxes, in a less daunting, straightforward way.

What are Taxes?

Taxes are mandatory financial charges all income-earners must pay on what they earn, buy, and own. Taxes are used to fund payment for public services such as public education, postal services, law enforcement, and healthcare. They are paid at the state and federal level because these public services occur separately at the state and federal level.

How Does the Tax System Work?

The tax system is set up in a way so that everyone pays their fair share of taxes. Out of the money you make and take home, there is a certain percentage that you must pay in taxes. The US has a progressive tax system, so the higher income you make, the higher percentage you pay in taxes. These different tax rates based on income are known as tax brackets. Tax brackets are what help make the system fair.

Taxable Income and Deductions

How much you need to pay in taxes is dependent on your taxable income, not your total income. Taxable income is what you have left over after any tax deductions. Deductions are expenses that can be subtracted from overall income to reduce the amount of total income subject to taxation. Everyone filing taxes in the US is given a standard deduction, which is dependent on your filing status. There are several other ways to get tax deductions, such as donating to charity, paying student loan interest, making retirement contributions, etc.

Tax Deductions vs. Tax Credit

Tax credit is a dollar-for-dollar reduction of the actual tax amount owed to the government. Tax deductions reduce the total amount of income subject to taxes. To get tax credits, you must check eligibility for specific credits and claim them on your income tax return. A tax return is a document that reports your income, expenses, deductions, and credits to determine your tax liability. While deductions and credit both reduce your overall tax bill, tax credits are considered more valuable because they reduce the actual amount you pay, not just the amount you can be taxed on.

How Taxes are Calculated

To calculate your taxes, you must first subtract all tax deductions from your total income to get your taxable income. Then, you apply the 7 federal tax brackets to your taxable income. After that, you subtract your tax credits from your initial tax liability.

Tax Incentives

Tax incentives are government-provided tax breaks designed to encourage specific economic behaviors. Let me put it simply: in order to maintain a thriving economy, we need to create jobs and provide affordable housing. Who creates jobs? Entrepreneurs. Who provides affordable housing? Real estate investors. Therefore, in order to grow our economy, the government provides entrepreneurs and real estate investors with significant tax breaks to encourage job growth and housing.

Types of Income

There are two types of income: earned income and unearned income. Earned income is money you get from actively working, whereas unearned income is money you get from not actively working. Examples of unearned income include stock profits, dividends, and interest income. You pay more taxes on earned income because they are subject to payroll taxes. Payroll taxes are imposed on employee wages to fund Social Security and Medicare. These taxes are split between employees and employers.

Unearned income is typically the best type of income for tax purposes because it is not subject to payroll taxes. As a teen, it is important to start investing early so that your investments can turn into unearned income later in life. This way, you can go from employee to investor as soon as possible, making you subject to less taxes.

How to File Taxes

If you are employed by someone else, you will receive forms to report your income from your employer. Additionally, if you made any investments, you will receive forms reporting deductions and any unearned income. Once you have gathered all of your forms, you must answer some questions on your tax return to reveal any other tax deductions or credits you may qualify for. At the end of filling out all of these forms, you should know your total tax paid and how much you owe or are owed.

Conclusion

Although taxes can be a daunting, complicated thing to think about, I hope this article effectively broke them down in simple terms. Filing taxes may not be fun or easy, but they are ultimately what keep our economy growing. If you made it all the way through this article, congratulations! To quote Albert Einstein "the hardest thing in the world to understand is the income tax." Now that you have a basic understanding of the US tax system, quantum mechanics and the theory of relativity should be a piece of cake. :)