Income tax is one of the hardest things to understand, even for brilliant minds like Albert Einstein. However, we don’t need to be Einstein in order to lower our income taxes. Income taxes are what organizations and individuals pay to the government based on the income that we earn. The money that is collected from income taxes is put into the government's general spending budget before being used for different fiscal policies.
How much we pay in taxes depends on our employment status and how much we earn and there are ways of lowering how much income tax we pay.
Tax withholding: W-2 vs 1099
Many of us are full-time salaried employees so we are considered a W-2 employee. W-2 employees benefit from employer-sponsored health insurance, retirement plans like 401(k)s or 403(b)s, and workers compensation; however, the employer also withholds the income taxes that we owe. Withholding means the employer will automatically remove the income taxes from our paychecks and send it to the government for us. The W-2 is the name of the tax form that our employer gives us every year showing what our total income was and the taxes we've paid based on that income.
For those of us who are self-employed or independent contractors, we are considered 1099 workers. As 1099 workers, we benefit from working to the beat of our own drum but that also means we do not have an employer to withhold income taxes for us. This means that we have to calculate and send our own taxes to the government each quarter (every 3 months).
If we forget to pay, the IRS will impose a late penalty of 0.5% per month that the taxes remain unpaid, capped at 25%. If we understate our tax bill by $5,000 or 10% of the correct tax amount (whichever is greater), then we can expect a 20% penalty that is imposed immediately.
As a W-2 employee, our final take-home paycheck is lower because our income taxes are calculated and paid on our behalf. On the other hand, 1099 workers typically have a higher take-home but we still have to calculate and pay income taxes. The majority of our taxable income is taxed on the Federal and state level; however, some local governments also have an income tax. How much we pay in income tax is often calculated based on income tax brackets but there are some states that use flat tax rates.
Federal and state income taxes
Federal taxes are what we pay to the federal government in order to pay for things like the military, safety net programs, government-sponsored research, education, salaries of politicians, and interest pay back on government-issued bonds.
Out of all the tax categories, we usually pay the most in federal income taxes. How much we pay is a percent of what we earn and that percentage varies depending on how much we've earned. As we earn more income, we will pay more in tax and the tax rate for the additional earnings will also increase. For example, we'll pay an income tax of 10% on the first $9,875 that we earn but the next dollar we earn will be taxed at 12%.
State income tax
Aside from paying federal income tax, most states have an income tax that we also pay. Every state has different tax rates. The states with the highest tax rates are California, Hawaii, Oregon, Minnesota, and Iowa. On the other hand, the following states don't have an income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. New Hampshire and Tennessee don't tax earned income either, but they do tax investment income.
State income taxes typically pay for public education, jails, social safety nets, healthcare in the form of Medicaid, public transportation, state police, and aid to local cities and governments. State taxes usually amount to a third or less of federal taxes. Some state income taxes are based on brackets similar to federal income taxes, like New York, while others are a flat tax rate across all levels of income, like Massachusetts.
Other taxable income
For most of us, salaries will be our largest source of taxable earned income; however, there are other sources of income to be aware of. As investors, we can earn returns in the form of interest and dividends. These cash payments are sources of investment income and can also be subject to income taxes.
Sometimes our employer will include equity in addition to our salary as compensation. Company stock awards are taxable and may show up on the W-2 depending on when exercising and selling occurs. Other lessons at Archimedes cover taxes owed on stock awards.
How do we reduce our tax liability?
Our tax liability is how much we owe in taxes. Lowering our tax liability can be a way to put more money in our pockets which enables us to spend or save as we please. We can lower our tax liability by either reducing our taxable income or reducing our tax rates.
First, we can reduce our tax liability by contributing to a qualified retirement plan. These include traditional retirement accounts such as 401(k)s, Traditional IRAs, and SEP IRAs if we are self-employed. One of the most important benefits of saving for retirement using these types of accounts is that the amount we contribute to the retirement accounts directly lowers what is considered our taxable income, and drops us to a lower tax bracket.
As more companies are adapting to working remotely from home, another way to lower our income tax liability is to relocate and earn our income in another state. While this might not be possible for all of us, moving from a state with income tax rates, which can be as high as 13.3% like in California, to a state with low to no income taxes can be substantial.
If possible, contribute to a qualified retirement account, such as a traditional 401(k). It greatly decreases the amount of taxes owed today and our invested retirement accounts will grow to be there for us when we need them in the future.