Taxes 101
Taxes are a crucial part of personal finance, providing the funds needed for essential public services like education, infrastructure, and healthcare. For most people, understanding the basics of taxes can demystify the process and help them manage finances more effectively.
In this post, we cover key tax concepts and types of taxes and provide you with five tips for tax planning to help you make the most of your income.
TYPES OF TAXES
There are several types of taxes in the U.S., each with a different impact on income and expenses.
Income Tax: This is a tax on earnings from various sources, including wages, salaries, business income, and investment returns. The federal government and most states have an income tax, which is progressive, meaning higher income brackets are taxed at higher rates. Deductions and credits can reduce income taxes by lowering taxable income or directly reducing tax owed.
Alternative Minimum Tax (AMT): The AMT serves as a parallel system to the regular income tax, designed to ensure high-income individuals pay a minimum level of tax, even if they qualify for many deductions and credits. Unlike regular income tax, the AMT recalculates income using its own rules, often excluding certain deductions and applying different rates. Taxpayers above a specified income threshold may be required to calculate their tax liability twice—once under the regular tax system and once under the AMT—and pay whichever amount is higher.
Sales Tax: Sales tax is applied to goods and services at the point of sale, and rates vary widely depending on the state and local jurisdiction. Some states exempt essentials like groceries, while others apply different rates based on the item category.
Property Tax: Property taxes are paid by homeowners and landowners based on the assessed value of their real estate. Collected by local governments, these taxes fund services like schools, emergency services, and public transportation. Property tax rates and calculation methods can vary significantly across states.
Capital Gains Tax: This tax applies to the profit earned from selling investments, such as stocks or real estate. The rate depends on how long the asset was held: short-term gains (on assets held for less than a year) are usually taxed as ordinary income, while long-term gains (on assets held for over a year) benefit from lower rates.
DEDUCTIONS, CREDITS, FILING STATUS
Tax deductions and credits are tools that can lower your tax burden.
Deductions reduce your taxable income, which can result in lower taxes owed. Examples include deductions for mortgage interest, student loan interest, and contributions to retirement accounts.
Credits, however, directly reduce the amount of tax you owe and can be particularly valuable. Common credits include the Earned Income Tax Credit (EITC) and the Child Tax Credit.
Filing status—such as single, married, filing jointly, or head of household—determines your tax rate and influences your eligibility for certain deductions and credits. Choosing the correct status is crucial for accurate tax filing and maximizing benefits.
STATE SPOTLIGHT: CALIFORNIA TAXES
California’s tax landscape is distinct due to its high state income tax rates ranging from 1% to 13.3% based on income. This progressive structure means higher earners pay significantly more. Additionally, California has a statewide base sales tax of 7.25%, with local rates pushing it to over 10% in some areas. California also has property tax regulations under Proposition 13, which include capping increases and basing rates on the property's purchase price with limited inflation adjustments.
TAX FILING AND DEADLINES
In the U.S., tax returns are typically filed annually by April 15. It’s important to gather necessary documents like W-2s (for wages), 1099s (for independent work or investment income), and receipts for deductible expenses. Filing on time and accurately is key to avoiding penalties and potential issues with the IRS.
QUARTERLY TAX DEADLINES
For self-employed individuals, freelancers, and others who don’t have taxes withheld through an employer, estimated taxes are due quarterly to cover income and self-employment taxes. Failing to pay these can result in penalties, so knowing the deadlines is crucial.
The quarterly tax deadlines are:
1st Quarter: April 15
2nd Quarter: June 15
3rd Quarter: September 15
4th Quarter: January 15 of the following year
These deadlines allow taxpayers to spread payments throughout the year, reducing the likelihood of a large tax bill at the end of the year.
5 TAX PLANNING TIPS
Tax planning isn’t just for tax season; making adjustments throughout the year can reduce tax burdens and maximize income.
Here are some strategies to consider:
Contribute to Retirement Accounts: Contributions to accounts like a 401(k) or traditional IRA can reduce taxable income, while Roth IRA contributions, though not tax-deductible, grow tax-free.
Track Deductible Expenses: If you’re itemizing deductions, tracking expenses like charitable contributions, medical costs, and educational expenses can reduce taxable income.
Consider Investment Timing: Holding investments longer than a year for long-term capital gains rates can significantly reduce tax liabilities compared to short-term gains.
Review Withholding: If you’re employed, ensuring the right amount is withheld from your paycheck can help you avoid a large bill (or a large refund) at tax time. Adjusting withholdings as your income or family situation changes can make a big difference.
Meet with a Financial Advisor: At DiversiFi, we help our clients craft tailored tax strategies that align with their financial goals. From identifying tax-saving opportunities to navigating complex tax scenarios, working with a financial advisor can help you approach tax season confidently and strategically. If you are interested in getting started, click here.
FINAL THOUGHTS
Understanding taxes may seem complex at first, but knowing the basics—types of taxes, deductions, credits, and planning strategies—can help you feel more confident. Taking the time to familiarize yourself with tax fundamentals can ensure you’re well-prepared when tax season rolls around and ultimately keep more of your hard-earned money.
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Past performance is not indicative of future returns, and investing always carries inherent risks, including the potential loss of principal capital. Any investment strategies are specific to individual clients and may not be representative of the experiences of all clients.
Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed.
Tax information given is provided as a general strategy and not intended as tax advice.