Taxes Part 2 of 4: Federal Income Tax Explained

It is mandatory that all Americans pay their income taxes each year. It is a lengthy process that can be explained in a few steps.

  1. Determining Taxable Income: Taxable income is the net income after deductions that income tax is computed. Not all income is taxed. Your total income (gross income), can include the following:
  • Earned Income: Usually wages, salaries, commission, tips, and bonuses
  • Investment Income: Money in the form of dividends, interest, or rent from real estate investments. It is also referred to as portfolio income
  • Passive Income: This is money that is earned by not actively participating in business activities, such as a limited partnership

Other income such as lottery winnings, alimony, and prize money won on game shows are also taxable income.

Gross income is also affected by exclusions (known as tax-exempt income), and tax-deferred income. Exclusions are income that is not taxed, and tax-deferred income is income taxed at a later date.

When reductions are made, gross income becomes adjusted gross income. An example of a reduction is medical expenses. Adjusted gross income is used to calculate income tax deductions.

Some adjustments are a kind of tax shelter, which are investments that provide tax benefits and an expectation of a financial return in the future.

2.   Computing Taxable Income: Tax deductions are now taken into account. Tax deductions are subtracted from the adjusted gross income to reach taxable income. A standard deduction is at least what every taxpayer receives, and is an amount on which no taxes are paid. However, some people qualify for more than just the standard deduction. They also qualify for itemized deductions, which are expenses you are allowed to deduct from the adjusted gross income. Itemized deductions can include:

  • Medical and dental – fees, prescriptions, hospital expenses, premiums, or medical travel that has been paid by you
  • Taxes – this includes any state, local, or real estate property tax
  • Donations – anything that has been donated to a qualified charity organization
  • Interest – interest from mortgages, home equity loans, and investments
  • Casualty – financial loss caused by natural disasters
  • Job-related expenses – job travel, required education, work clothing, or anything work related that was not reimbursed

Another kind of deduction that can be subtracted from the adjusted gross income is an exemption, which is a deduction from your adjusted gross income for yourself, your spouse, and qualified dependents.

Note: A person can qualify as a dependent if they are related to you, are under 19, or under 24 if a full-time student, live with you for more than half the year, and be financially supported by you. They may have a job, but it should not provide more than half of financial support.

3.  Computing Taxes Owed: This is where taxable income comes into play. It is needed to determine the amount of taxes owed, along with the appropriate rate on taxable income. An example of a tax table is below.

Each tax rate represents an income level, known as a bracket.

The first 7 (10% to 39.6%) percent rates are known as marginal tax rates, which are rates that are used to calculate tax on the last dollar of taxable income. However, the average tax rate is based on total tax due divided by taxable income. This rate is lower than someone’s marginal tax rate, excluding taxpayers in the 10% tax bracket.

The taxes owed can be reduced with a tax credit, which is an amount subtracted from the taxes owed. Examples of a tax credit include The Child and Dependent Care Credit, and The Retirement Savings Contributions Credit. This is not to be confused with a deduction. A tax credit directly reduces the amount of taxes owed, while a deduction depends on the taxpayers’ marginal tax rate.

  1.  Paying Taxes: Payments are made either through withholding payroll or estimated tax payments.
  • Payroll: The pay-as-you-go system requires employers to deduct federal income taxes from wages. The amount that is withheld depends on the number of exemptions and deductions claimed. So, the amount withheld from a person who is married with children would be less than that of a single person with the same pay, since the married person owes less tax. At the end of the year, you will receive a W-2 form that is a breakdown of annual earnings and amounts deducted for taxes. The difference between the withheld amount and the amount of taxes owed can either be your refund, or what you need to pay.

Note: Students and low-income individuals can file for an exemption from withholding if they have not paid federal income tax the previous year and do not plan on doing so in the current year.

  • Estimated tax payments: People who receive income from savings, investments, pension payments, and royalties are required to make tax payments during the year. The payments are based on an estimate of taxes due at the end of the year.
  1.   Meeting the Deadline: It is required that a federal income tax return must be filed by April 15th. If in an event that you cannot, you can always acquire a six-month extension using Form 4868. This pertains to 1040 forms and others but does not delay your obligation to pay. It is mandatory that you submit form 4868 with the estimated amount owed by April 15th to avoid a penalty. Failure to pay the full amount owed can result in interest charges on the amount you should have paid.

Note: If you claim a refund several months/years late, but within three years of filing or within two years of paying the tax, the IRS will pay you interest.  

 

Filing your federal income taxes seems like a prolonged development, but it is beneficial to know what goes on throughout the process.

 

 

Taxes Part 1 of 4: The Big Four


Taxes are the most sought-after topic young adults wish to understand because it is a huge part of everyday life. When people hear the word ‘taxes’, feelings of confusion, annoyance, and frustration are evoked. Some even think, “I earned the money, why is it being taken from me?” Taxes are paid when you purchase items and earn a paycheck. Taxes are also paid on four main categories: purchases, property, wealth, and earnings.

Purchases

Taxes on purchases are also known as a sales tax. Formally, it is known as an excise tax, which is enacted on goods and services such as gas, cigarettes, hotels, and airfare. To reduce the financial burden on households with low income, many states have exempted sales tax from food and drugs.

Property

Taxes on property, or real estate property tax, is based on the value of land and buildings. Over the years, property tax has increased drastically. Property tax is also a big source of revenue for local governments.

Wealth

When a person passes away, a tax is imposed on the value of their property called an estate tax. The taxed property could include investments, property such as land and buildings, and bank accounts. Often times, there is an heir that inherits the property. In this case, the property is subjected to an inheritance tax, which is paid to acquire the property.

Earnings

I’m sure that you look at your paycheck and wonder where a big chunk of your pay has gone to. There are two main taxes on wages: Social Security and income taxes. Social Security funds people aged 62 and up, survivors, disability, and Medicare. Income taxes include federal, state, and local income taxes.

 

There is a lot of planning involved when it comes to taxes, which is why it is important to fully understand the various kinds of taxes you pay.

 

7 Steps Towards Budgeting

The United States is a market economy. We live in a consumer culture, where the economy is focused on the selling of consumer goods. This makes saving and budgeting difficult since most people are impulsive to spend. Therefore, before anything else, the most crucial step to becoming fiscally responsible is to learn self-control. The sooner you learn to control your impulses to spend, the easier it will be for you to budget and save.

When it comes to controlling spending habits, the most recommended method is to start a budget. A budget is a spending plan that is crucial for successful financial planning. Budgeting can implement a regular savings program, limit the overuse of credit, and assist with future financial security. The sole purpose of a budget is to help you live within your income. It helps you spend wisely, reinforce financial management practices, and reach financial goals.

Budgeting can be achieved with the 7 steps below:

  1. Set financial goals: Make sure your goals are clear and attainable by utilizing the SMART acronym (Specific, Measurable, Action-oriented, Realistic, and Time-based)

Example: I plan to save $5,000 for a down payment on a new car by saving $200 from each paycheck for two years.  

    2.  Estimate your income: Take into account fixed income, such as your salary, that will be available for a period of time. It is best to do so on a monthly basis since most expenses are due each month.

 

   3.  Create an emergency fund: To prepare for unexpected expenses, set aside money to budget in case of an emergency.

 

   4.  Budget fixed expenses: Set aside money for expenses that you are obligated to pay, such as rent, car payments, credit card bills, or insurance.

 

   5.  Plan for variable expenses: Budgeting for variable expenses is a bit difficult than budgeting for expenses that are fixed. It is best to plan for them by using past spending as an estimate.

 

   6.  Track your spending: Keeping an eye on income and expenses allows you to compare actual amounts with budgeted amounts to determine variances.

 

   7.  Review: Since budgeting is an ongoing process, look over your spending plan to spot revisions that need to be made.

Note: A common mistake people make is to save the amount of money that is left over at the end of the month. This is unwise as there is often nothing left. Saving is a critical part of long-term financial security, so remember to always pay yourself first.

The Latte Factor

It is important to be conscious of your spending. A well-known money-saving strategy is The Latte Factor, coined by David Bach. It explains how unconscious spending on the smallest purchases, like a latte, adds up to a huge amount over time. It also explains how buying everyday items that have little to no value in life hinders savings.

 

Starting a budget can go a long way, even if you’re putting aside a small amount of money in your savings. It’s better to be prepared for emergencies, rather than borrowing money on credit and risk ending up in financial trouble.

Applying for and Managing a Credit Card

 

As young adults venture out into the “real world”, it is important to establish a credit history. Now, since you are young, that means you have little to no credit history. This is where the need for a credit card comes in. You may be unsure or feel confused about the process of obtaining and managing one, but credit cards are not as stressful as they seem to be.

How Do I Get a Credit Card?

To apply for a credit card, you must be at least 21 years old. Many people at this age have no credit and are often the ones who struggle to get approved for a credit card the most. This is because institutions need to look at your credit score to issue a credit card but to have a credit score, you’ll need to have an active credit card account on your credit report for six months.

Feeling overwhelmed? Don’t be.

This is where that part time job you’ve been working at while going to school finally pays off. Credit card issuers need to see that you have a sufficient income to pay off your credit card balance. Keep in mind, it must be money earned by you. That excludes your parent’s, spouse’s, or other members of your household’s income. The higher this amount is, the better your chances are of being approved for a credit card without a credit score.

Note: If you are unemployed or earn a small salary, you can include money you get from scholarships and grants

If you are a student, I highly recommend applying for a student credit card. Specifically, the Discover it for Students Card. I use it and it’s made it easy for me to build my credit since it has no annual fee and I can earn cashback rewards for getting good grades and from qualifying purchases. It also offers cashback match, which matches the amount you’ve earned in rewards at the end of the year (The Cashback MatchTM is a promotional offer and therefore may not be available in the future). You can use the cashback rewards to pay off your minimum balance, redeem it as a gift card, or have it electronically deposited to your bank account. Student credit cards are tailored to college students who don’t have a large income or credit history. To qualify for a student credit card, you must provide proof that you are enrolled in an accredited college or university.

I’ve Been Approved. Now What?

Congratulations, you’ve been approved for a credit card!

Here comes the managing part. Being a credit card holder comes with a lot of responsibility. There are a lot of things to keep an eye on, such as an annual fee (if applicable), late fees, annual percentage rate (APR), your credit line, and minimum balance. Let’s go through each of them.

Annual Fee: An annual fee is separate from the interest rate fee. It is charged by credit card companies each year for using a credit card. Remember, not all credit cards have this. When looking for a credit card, avoid ones with an annual fee to dodge this extra cost.

Late Fee: A late fee is applied when you fail to pay the minimum balance. To avoid this, make sure to pay the minimum balance by the due date specified. To further avoid this, make sure you charge amounts to your credit card that you are confident you can pay back.

Minimum Balance: The minimum balance is the amount owed monthly. If it is not paid in full, it will be carried over to the next billing period. This will incur late fees and interest rate fees. Once again, to avoid this make sure you charge amounts to your credit card that you are confident you can pay back.

APR: The APR, or annual percentage rate, is the interest rate charged each month when there is an outstanding balance present. Again, you can avoid this by charging amounts to your credit card that you are confident you can pay back. The APR depends on what the issuer is offering and can be variable.

Credit Line: This is also known as a credit limit. It is the maximum amount that can be charged to a credit card. This amount, and how much has been borrowed from this amount, affects your credit score. So, a credit line that doesn’t have much borrowed from it can result in a high credit score.

Credit Can be Dangerous

Misusing a credit card can create long term financial problems. Be sure to use credit cards wisely, as they can tempt people to overspend, result in bankruptcy, and loss of creditworthiness.

 

Getting approved for a credit card gives you financial freedom, but be sure to use your credit responsibly. Keep balances low and pay the full amount each month. Implementing these practices can qualify you for more credit cards and even loans in the future.

The Significance of a Credit Score

What’s a Credit Score?

Ultimately, a credit score reveals the information in your credit report. This number is an overview of your credit history. A credit score allows creditors to determine how likely it is that you will make on time payments. Creditors also use a credit score to grant you credit, to decide what terms to offer you, and to determine the interest rate you pay.

What is Involved When Calculating Your Credit Score?

There are a number of factors that are taken into account when calculating your credit score such as, the amount of accounts you have, the type of account it is (credit cards, mortgages, auto loans), whether or not you make on time payments, how much outstanding debt you have, how old your accounts are, and how much of your available credit you are using.

Is There a Difference Between a FICO Score and a VantageScore?

Yes. Your FICO score is a result of the information in your credit report. This number, usually between 350-850, measures how risky a borrower is. So, the higher your FICO score is, the less of a risk you are to creditors. A VantageScore is developed by the three credit bureaus: Experian, TransUnion, and Equifax. This creates a better forecast of your credit, even if you have little credit history. It also eliminates the need for creditors to manually review your credit information. VantageScores range from 501-990, and again, the higher your score, the less of a risk you are to creditors. A pro of a VantageScore is as long as the three credit bureaus have the same credit information, then all three scores will be the same. If the credit bureaus have different scores, then that is an indication of discrepancies in your report.

How do You Maintain a Good Credit Score?

There are a number of things you must do to maintain a good credit score:

  1. Peruse your credit report to make sure that it is accurate. There are many websites that claim they will give you your credit report for free, but then end up asking you for payment information. To avoid scams like this, go to annualcreditreport.com. This website is the only one that has the authority to give you your credit report for free.

 

  1. Pay all of your bills on time. This is the most important step to take to make sure you have a good credit score.

 

  1. Be familiar with the factors that determine your credit score such as, paying bills on time, having outstanding debt, the length of your credit history, if you’ve applied for a new line of credit, and the type of credit accounts you have and how many there are.

 

  1. Be informed about the legal steps you can take to fix errors in your report. A good source is The Federal Trade Commission’s Building a Better Credit Report

 

  1. Be mindful of credit repair scams. You can use The Federal Trade Commission’s Credit Repair: How to Help Yourself to maintain and improve creditworthiness. It’s like they always say, “When you want something done right, you gotta do it yourself.”

 

Your creditworthiness solely depends on your credit score. Not maintaining a good credit score can make you vulnerable to high interest rates and disqualify you from getting a new loan. It can also ruin your chances of getting that new job or apartment. Always remember that the higher your credit score, the less risky you will look to creditors.

Taming College Tuition

Congratulations! After 4 long years of high school, you’re officially college bound.

Getting into college is a huge accomplishment. College shapes you to become the person you aspire to be. Unfortunately, those aspirations come with a price – a very high, intimidating price. The cost of college tuition has skyrocketed and will continue to do so. Lucky for you, there are a few ways you can be relieved of these high prices, such as applying for FAFSA, TAP, scholarships, and opening a 529 plan.

Free Application for Federal Student Aid (FAFSA)

FAFSA is an application used by the federal government to determine how much money should be given to students in the form of grants, loans, and work study programs. The application uses your or your family’s tax information to determine the specific amount of each. This can be filled out each year you are in school. It will not automatically renew each year, so you must remember to fill it out at the beginning of the year to continue receiving federal aid. You can only access it at www.fafsa.ed.gov

As I mentioned, FAFSA gives federal aid in the form of grants, loans, and work-study programs. There are major differences between the three.

Grants: FAFSA awards the Federal Pell Grant to undergraduate students who are pursuing a bachelor’s degree. This amount depends on financial need and is free money, meaning it does not have to be repaid.

Loans: A loan is a sum of money that is borrowed and paid back with interest. FAFSA gives out various loans, but the one I recommend the most is the Direct Subsidized Loan. This type of loan is available to undergraduates, where the U.S. Department of Education pays the interest on the loan while you’re in school at least half-time, for the first six months after you leave school (this is referred to as a grace period), and during a period of deferment (a postponement of loan payments).

Work-Study: Work study programs provide students with part-time jobs to help them pay for school expenses. This is available to full-time or part-time undergraduate, graduate, and professional students with financial need. It is only administered by schools participating in the Federal Work-Study Program. You can find out from your school’s financial aid office if they are participating.

Note: fafsa.ed.gov is the only website where the FAFSA application can be filled out. It is a free resource. Any other website requesting payment for filling out a FAFSA application is a SCAM.

Tuition Assistance Program (TAP)

The Tuition Assistance Program is a part of The Higher Education Services Corporation (HESC) and is another form of federal aid. TAP is a grant that ranges from $500 to $5,000. The specific amount is determined by family income and tax status. Since it is a grant, it does not need to be repaid. Unfortunately, it is only applicable to New York State residents who are attending or going to attend school in New York. To be eligible, you must be a United States citizen and a New York resident. Your tax information is automatically sent to HESC when you fill out the FAFSA application, so you don’t have to worry about filling out two separate forms.

Scholarships

Scholarships are merit-based awards given out by various institutions. There are thousands of different kinds of scholarships out there for anyone. Because of this, it does make it difficult to win one. When applying for scholarships, keep in mind that it is not a guaranteed win.

Remember, it’s you against everyone else who is trying to pay for school and that is a lot of people. However, this shouldn’t stop you from applying because you’ll never know if you don’t try. Some scholarship websites I recommend are fastweb.com and niche.com. For the fall semester, start applying from January to May. For the spring semester, start applying from August to October.

Some colleges even award scholarships to incoming freshman based on their high school GPA. These scholarships will be awarded every year if you maintain your GPA. Check with your school’s financial aid office for more information.

529 Plan

A 529 plan is a savings plan created for setting aside funds for future educational costs. It is tax-deferred and varies by state. This plan will be worth more if an account is opened a few years before you start college. It is authorized by Section 529 of the Internal Revenue Code. You can find out more about it on the Securities and Exchange Commission’s website at https://www.sec.gov/reportspubs/investor-publications/investorpubsintro529htm.html

 

By taking advantage of these resources, you can decrease the stress and burden that comes with paying college tuition and focus on your academic pursuits.