Making It On Your Own: Taxes
When you start working, you’re responsible for paying a variety of taxes. Learn tax basics in the second chapter of Aspiriant’s monthly financial education series for young adults, Making It On Your Own.
Congratulations! You just finally landed that first “real” job. Now get ready, because one of the hallmarks of growing up is you have to pay income taxes.
When you start working, whether or not you’re still living with mom and dad, you’ll be responsible for paying a variety taxes. Know that:
· Everyone working in America is required to pay tax on all income — even if you’re paid cash for baby-sitting or yard work
· Income taxes are due as they are earned and are paid through deductions from your paychecks
· Depending on your income, you must file an annual tax return with the IRS on or before April 15 each year, and keep detailed income and expense records
But don’t sweat it. Chances are your first few tax returns will be pretty straightforward, given that your financial situation probably isn’t that complex yet. Most of us, when we start out, have job wages to account for but don’t yet have multiple sources of income. And there are ways for you to minimize the total tax you owe.
As long as you stay organized and start working on them early, they’ll be fairly easy. Here, we provide some of the basics you need to know to be smart about taxes.
Paying as you go
Nearly everyone goes through first paycheck shock — the moment you realize the amount paid to you is much lower than what you actually earned.
That’s because your employer is required by law to deduct federal and state income taxes, and additional amounts for federal “safety net” programs like Medicare and Social Security, from your regular paychecks. You might recall filling out a Form W-4 when you started your job. The “allowances” you stated on that form tells your employer exactly how much to deduct for taxes. The employer then reports and pays these amounts to the IRS and state tax agencies.
Whether your employer is a small company, a major corporation or a college, you’ll get a paycheck or bank direct-deposit slip, plus a “pay stub,” a statement listing your total hours and earnings for that pay period.
The pay stub also lists the mandatory deductions your employer has taken out for your federal and state income taxes. You’ll also see deductions for Social Security, Medicare and Disability Insurance for that period — as well as any deductions for fringe benefits you’ve chosen, like medical coverage and 401(k) retirement savings.
Depending on your benefit choices, expect that your take-home pay will be 20% to 30% less than your total earnings. This lower “net earnings” amount is the income figure you should use to plan your budget, monthly expenses and spending.
Tax returns: Make them easy with technology
Almost more distasteful than watching your income shrink from tax deductions is the task of filing your annual tax return.
It’s true that tax regulations are complicated; literally thousands of pages of legalese. But filing really doesn’t have to be that daunting if you know the basics.
Linda Kitchens, a wealth management director and principal at Aspiriant, a national wealth management firm, encourages young adults to do their own tax returns initially. “It’s important throughout your entire life to understand the basics of income tax. Other than your family, perhaps the longest relationship you will have is with the U.S. Treasury,” she says.
Your income taxes are based on the calendar year, January 1 through December 31. By the end of the following January, each of your employers will send you a Form W-2 with your last-year’s total earnings, taxes paid and other contributions. You’ll also get earnings and interest reports from your bank and any investment accounts. Be aware that you must save your annual tax records for at least three years (longer if unusual circumstances apply).
If you’re single and not being claimed as a dependent on someone else’s tax return, you must file a federal tax return if you earned at least $10,350 in a year.
If someone can claim you as a dependent (be sure to ask!), then you would have to file if anything below applies to you:
· You earned more than $6,300
· You have more than $1,050 of unearned income (such as interest and dividends)
· Your gross income is more than the larger of a) $1,050 or b) your earned income up to $5,950, plus $350
Your state has its own requirements, so be sure to look into them.
But even if you didn’t make this much, you may still want to file a return to get a refund, if you had taxes taken out of your paychecks. It is your money, after all. And a couple hours of work could be worth it.
There is an easy income tax form (1040EZ) if you want to simply take the standard deduction. But it might be worthwhile to prepare a more complex tax return (1040 plus Schedule A) if you may be entitled to enough tax breaks that amount to more than the standard deduction.
“Today, tax preparation software makes filling out a return as easy as posting to Instagram — OK, maybe not that easy, but much easier than it used to be,” says Myles Rush, a manager in wealth management and principal at Aspiriant. “Also, don’t forget you can ask your parents for help! I remember my dad helping me fill out my first few tax returns.”
Also, major banks can upload your monthly checking, savings and credit card statements directly into your computer’s personal money-management software. At the end of the year, your software can create a tax report with spending totals by category — virtually all the figures you or your tax preparer need to file your taxes.
Eventually, as your financial life gets more complex — from things like investments, rental properties, or possibly a small business — a tax advisor could be a great help.
Your big tax breaks
U.S. tax regulations are designed to encourage behavior that’s considered desirable, providing a range of deductions that lower your tax bill — for instance, being married, raising children, home ownership, charity, etc. There are also tax deductions for certain expenses like using your own special tools or vehicles to do your job and out-of-pocket co-pays for medical expenses, among others.
If you qualify, properly claim and document these deductions on your tax return. They could save you hundreds or thousands of dollars in taxes.
The tax code also provides a major tax break to help you save for retirement. You can set aside a portion of each paycheck into a 401(k), if your employer offers one, or make regular deposits into a traditional Individual Retirement Account (IRA).
Every dollar you save in these investment accounts (up to allowable limits) reduces your taxable income. And the investment income that you earn inside your retirement account is also tax-deferred, which helps it compound and grow over time.
And if your employer matches the amount you save in your 401(k), that’s an extra bonus.
“An employer match is like doubling your money before you even think about how to invest it,” Linda says.
Lower your taxes now and build retirement income for later? That’s a great deal. Take it.
Plan ahead and don’t procrastinate
Filing taxes is lifelong homework. As you’ve probably learned during an all-night study session, procrastination is not your friend. Keep tax-related receipts in one convenient place all year long. And don’t wait until the last minute to get started.
Be prepared that you may owe money if not enough tax was taken out of your paychecks. If that is the case, fill out a new Form W-4 with lower allowances to prevent it happening again next year. But hopefully you’ll get a refund to have fun with or set aside in your traditional IRA (if you want to get ahead saving for next year). And that’s when filing taxes can be exciting.
“Taxes may seem extremely intimidating and impossible to understand, but they’re not. There is logic to them,” reassures Myles. “The best way to become more comfortable is to dive right in and learn more about how they work.”
(Source: Tax filing requirements for 2016, latest information available from the IRS.)