We all know some of the most basic things every taxpayer should know. We [usually] know the date to file by, what our filing status is, and for what fiscal year we are filing. These things typically go without saying, but because tax code seems to
be too difficult for most of us to fully grasp, we often ignore some of the things we should add to our knowledge of preparing and filing our taxes with the attitude of “ignorance is bliss”. And while an “ignorance is bliss” approach might save you some sanity when your kids are shaving your dog or attempting to eat a piece of candy of indeterminate age, it doesn’t have a whole lot of sway with the IRS. That being said, there are a few things every taxpayer should know. These things can save a lot of money, as well as a significant amount of stress when it comes time to prepare your taxes.
Know the Difference Between Taxable and Non-Taxable Income
Do you know what the difference is? It seems self-explanatory; but it can get a little tricky trying to determine whether income is taxable or non-taxable, and is one of the top 5 things every taxpayer should know. Generally speaking, all income is taxable. But not all money you receive is considered taxable income. Confused yet? Indeed. Me too. So let’s break it down a little bit to make it easier to digest. Let’s suppose your great-great-great-aunt’s cousin, Mildred, has unexpectedly passed away at the age of 109 (or 108–the age doesn’t really matter here). Mildred leaves a chunk of money to you as an inheritance. That inheritance is not considered taxable income in most states. Other types of non-taxable income include child support, life insurance, and gifts. Income earned from a job, interest on investments, capital gains, wages, salaries, tips, and commissions ARE considered taxable income and need to be reported as such. For more details on how different types of income are classified, click here.
Things Every Taxpayer Should Know: Social Security CAN be taxable
Most people don’t realize that social security benefits can absolutely be taxable income. In cases where social security is the only source of income, then it most likely won’t put you into a tax bracket in which it is taxed. One of the things every taxpayer should know, however, is that if you combine social security with other forms of income, it raises you into a higher tax bracket. That makes the social security income taxable income.
Understanding Tax Brackets
Most of us know that different levels of income are taxed at different rates. What most people don’t know is that if your income seeps into a higher tax bracket, you don’t pay a higher rate on your ENTIRE income. You only pay a higher tax on the amount that pours into the higher bracket. It can save you a lot of money in taxes if you understand these brackets and pay your taxes accordingly.
Credits and Deductions
One of the things I have recently learned is that credits and deductions are not the same thing. Understanding the difference between credits and deductions can be extremely beneficial when preparing your taxes, and looking for credits for which you are eligible can greatly reduce your taxable income. When it comes to preparing your taxes, credits are ultimately better than deductions. Credits reduce your taxes dollar for dollar, so a $500 energy credit will reduce your taxes by $500. Deductions, on the other hand, only reduce your taxable income by a percentage. Sure, some deductions will reduce your taxable income substantially more than a small credit. But a $1000 deduction for somebody in a 15% tax bracket will only reduce your taxes by $150. It is important to note that many of your credits and deductions can disappear as your income rises. Once your income reaches certain levels, you may no longer qualify for the same tax breaks you once did. By knowing which ones you qualify for, you might be able to do some tax planning which will help you preserve as many of these breaks as possible.
Itemizing Deductions for Maximum Savings
You don’t HAVE to itemize your tax returns to take advantage of some common deductions. But itemizing your tax return allows you to deduct substantially more on your personal taxes, which maximizes your tax savings. These personal deductions can include a portion of your cell phone bill, gasoline, clothing, or other expenses linked to your job. On the flip side, there are plenty deductions which are available above the line if you choose not to itemize. These commonly include student loan interest, educator expenses, paid alimony, and penalties on early withdrawal of savings.
Most Important Things Every Taxpayer Should Know: How Much to Withhold
A lot of people are tempted to withhold more than they should from their paychecks. The thinking is that it will allow for a larger refund come tax time. Yes, it absolutely gives taxpayers a bigger refund check. But that money is also being held by the IRS interest-free throughout the year. The money would better serve taxpayers in a savings account. Even a low-interest savings account will be more beneficial to a taxpayer than zero interest from the IRS. Instead, consider adjusting your withholding to reflect a more accurate estimate of what you will owe the IRS and invest the difference in a high-yield savings account. It is, after all, YOUR money. You shouldn’t have to wait until tax time to be able to have access to it.
These things every taxpayer should know are not an all-inclusive list. The tax laws and codes can become quite complicated, but working with your tax professional and brushing up on some of the easier aspects of the tax laws and codes can ultimately help you save a significant amount on your debt to the IRS. Of course it also helps to know how changes in tax laws and codes will affect you personally. Reading up on tax extenders annually can help you decide how these changes will impact your tax accountability. If nothing else, they can certainly be an excellent cure for insomnia.