Understanding Taxes

Overview:

In Module 6, we explored the importance of retirement planning and strategies for saving for retirement. Now, in Module 7, we will delve into the basics of taxes and their implications for personal finances. Taxes are an integral part of financial planning, and understanding how they work is essential for managing money effectively. In this module, we will cover different types of taxes, tax filing processes, and strategies for optimizing tax efficiency, with examples from recent news.

Learning Objectives:

• Understand the basics of taxation and its impact on personal finances.
• Learn about different types of taxes and how they are collected.
• Gain insights into tax filing processes and strategies for minimizing tax liabilities.

Types of Taxes

There are different types of taxes levied by the government, common examples are:

• Income tax: A tax imposed on individuals and businesses based on their income, with rates varying depending on income levels and filing status. In most cases, income taxes are through the employer as they are withheld from the individual’s income. However, the individual would notify the employer of her filing status which would form the basis for the amount withheld. The individual might equally decide not to have the tax withheld, in this case, the individual would make the payments at the filing period.
• Sales tax: A tax levied on the sale of goods and services at the point of purchase, with rates determined by state and local governments. Upon the closure of the sales transaction, the buyer would pay the sales tax including the agreed sales. The seller would then reimburse the government through pre-arranged means.
• Property tax: A tax assessed on the value of real estate property, used to fund local government services and infrastructure. Property taxes are mostly paid through an escrow arrangement setup as part of the property mortgage. In this case, the tax is paid upfront by a resolute agent and all shortages/excesses are reimbursed by/to the property owner at the end of the year.

Notable Nuances in Tax filing processes

The tax filing process involves several important decisions and steps that taxpayers must navigate to accurately report income, reduce taxable income, and calculate tax liabilities. The following points highlight key considerations in filing taxes effectively.

• Annual Tax Return Requirement: Individuals are required to file tax returns annually to report their income and determine tax liabilities. The process involves collecting necessary financial documents, such as W-2s, 1099s, and investment statements, to accurately report income from various sources. Taxpayers must also account for any credits or deductions they qualify for, which can help reduce their overall tax burden. Failure to file on time may result in penalties or interest charges.

• Deductions: Taxpayers can choose between the standard deduction, which is a fixed dollar amount based on filing status, and itemized deductions, which involve listing eligible expenses such as mortgage interest, charitable contributions, medical expenses, and state/local taxes. Opting for itemized deductions is typically beneficial when these expenses exceed the standard deduction amount. Properly selecting between these options can significantly impact the amount of taxable income and ultimately lower the tax bill. Understanding how each type of deduction works and keeping thorough records is essential for maximizing potential tax savings.
• Filing Statues: Taxpayers must select a filing status that accurately reflects their household situation, such as Single, Married Filing Jointly, Married Filing Separately, Head of Household, or Qualifying Widow(er). Filing status impacts the tax brackets, standard deduction amounts, and eligibility for certain credits. Choosing the correct status is crucial for optimizing tax outcomes and avoiding complications.
• Tax Credit: Beyond deductions, taxpayers can also reduce their tax liabilities through various credits, such as the Earned Income Tax Credit (EITC), Child Tax Credit, or education-related credits like the American Opportunity Credit. Unlike deductions, tax credits provide a dollar-for-dollar reduction in tax owed and, in some cases, can result in a refund even if no tax is owed. Knowing which credits apply can result in significant savings.

Strategies for Minimizing Tax Liabilities

For corporations, tax planning strategies can be effective in offsetting capital gains taxes amid market gains. Equally, for individuals, having a tax strategy can impact your overall financial stamina and health, that is, by minimizing your tax liabilities and maximizing after-tax returns. Overall, it is always better to solicit the services of a tax professional for obvious reasons. Tax filings can be complicated based on the status of the tax bearer and there are always changes to tax codes, filing processes, and standards. In any case below are few tips,

• Consult with a tax professional: Seek advice from tax professionals or financial advisors to optimize tax planning strategies and ensure compliance with tax laws.
• Have taxes withheld upfront: Having your taxes withheld by your employer (or any legitimate third party) saves you from finding yourself in a situation where you owe taxes at the end of the fiscal year.
• Take advantage of tax deductions and credits: Maximize deductions for expenses such as mortgage interest, charitable contributions, and medical expenses to reduce taxable income.
• Contribute to tax-advantaged accounts: Invest in retirement accounts like 401(k) plans and IRAs to enjoy tax benefits such as tax-deferred growth or tax-free withdrawals.

Key Takeaways:

Taxes are an integral part of financial planning and impact personal finances in several ways.

Understanding several types of taxes and tax filing processes is essential for managing money effectively and minimizing tax liabilities.

Implementing tax planning strategies, such as maximizing deductions and contributions to tax-advantaged accounts, can help individuals optimize tax efficiency and achieve financial goals.

Next Steps:

In Module 8, we will explore the basics of insurance and its role in protecting against financial risks. Stay tuned for Module 8: Insurance Basics with The House of Emmanuels Foundation.

Thank you,

Author,
Ogbeni Ridwan (Lawyer; Banker; IT Audit Manager)
Director, The House of Emmanuels Foundation
Raleigh, NC USA