This is a mini site about taxes. If you're not familiar with taxes, there's some basic information here. The articles at the top are essays, and the articles toward the bottom are a glossary of sorts. For the most part, this site is for residents of California.
I'm not a tax professional or an accountant, or even a bookkeeper. I just like to do my own taxes.
Important Links
Internal Revenue Service - the Federal government agency that collects income taxes.
CA Franchise Tax Board - the State of California's agency that collects income taxes.
(It's ok to click the links. These are not affiliate links.)
First, see the IRS Free File Program that links to several websites that offer free tax prep software for simple returns. To use Free File, your adjusted gross income must be less than $57,000.
TaxACT - basic prep software to do the short and long forms as well as what seems to be all the common small business forms. Doesn't offer "advice wizards" like TT or H&R Block. Online or Windows only.
H&R Block at Home - basic to advanced. Some versions do Schedule C and other business forms. Comparable to TurboTax. This used to be called TaxCut. Available for Mac and Windows.
In the past four or five years, I've used all these apps. TaxAct is simple and plain (and cheap). TaxCut (H&R Block) is like TurboTax, but with less help. TurboTax has the most help and advice, but is also gives you the most "maze like" experience.
If you're new to tax prep, H&R Block is a good way to learn. If you already know tax prep and basically have the same return as last year, TaxACT is probably easier than the other two, because you can deal with your taxes by filling forms rather than having Q&A interations with "wizards."
Also, if you have a micro business, rent property out, or lots of 1099 income, something to try is to purchase the more expensive software one year, and use all the wizards, and really learn the tax forms. Then, the next year, purchase TaxAct, and use your past return as a guide to preparing your next return. This will work if your income sources are similar year after year, and the business tax laws don't change significantly (and you regularly read a business magazine to keep on top of what deductions are available).
This isn't relevant, but J Archer has free Linux tax prep software. Talk about a cool hack: writing your own tax prep software to do your return.
Also, some states have free online tax filing. California, for example, has two different online forms. One's called Ready Return, and is almost one-step filing. The other is called CalFile and is more like a traditional filing program, with multiple income sources, deductions, and other tax features.
People get tax credits and tax deductions mixed up.
A tax credit is money the government gives to you.
A tax deduction is money that the government won't tax.
Tax credits are more valuable than tax deductions. Here's a fantasy example of how a tax credit works.
Once upon a time, in one year, you earned $1000. The IRS said they would take 1% or $10 of that in taxes. However, you purchased a tent to live in, and the government was giving a $1 tax credit for tent dwellers. (Assume the tent was really cheap, too.) That tax credit is applied to your taxes... and your final tax bill is $9! The $1 tax credit was given to you.
Here's a similar story about a tax deduction.
The next year, you earn $1000, and the tax is the same: 1%, which is $10. However, you just bought a skateboard for $100, and the government is allowing skateboarders to deduct the cost of a skateboard because it's basic transportation. So, you have a $100 deduction! A deduction is subtracted from your taxable income. That means your taxable income drops to $900. Taxes are 1%, so, your tax bill this year is $9. (Same as last year!)
Notice how in the first example, you spent almost nothing, and got at $1 tax credit, and your tax bill was $9.
In the second example, you spent $100, and got a deduction, and then your tax bill was $9.
The tax deduction was like a $1 off coupon on that skateboard. So, thanks to that deduction, your $100 board really only cost $99. Whoop-de-do.
It's much better to do things that get you tax credits, than to do things that get you tax deductions.
It's even worse
Yes, it's even worse than the little stories. To get some itemized deductions, your spending must exceed some threshold, and usually that threshold is several hundreds to a few thousand dollars.
Also, my examples were totally unrealistic. Taxes are a lot higher - in the range from 10% to 38% - and incomes are a lot higher. The numbers were chosen to make a point: that tax credits are $$$ in your pocket, while tax deductions are like discounts for spending money in specific ways.
An alternative calculation
Another way to look at the examples is to say that a $1 tax credit is equal to a $100 tax deduction.
If taxes were higher than the example it's not so drastic. At the 25% tax bracket, a $1 tax credit is equal to a $4 tax deduction. A $1,000 tax credit is like a $4,000 tax deduction.
The $8,000 homebuyer credit is equal to a $32,000 deduction. (Another way to say it is: if you buy a house, you're not going to pay much or any income tax.)
Also published at AC: Comparing a Tax Credit with a Tax Deduction.
Turbo Tax maker Intuit, again, is mired in political turmoil: Intuit was upset that John Chiang, our State Controller, had been making electronic tax filing software free to people. Intuit wanted the State to use a different system that worked with Intuit's commercial software.
So, Intuit spent over a million dollars to run a candidate against Chiang.
That begs the question: shouldn't the state provide free software to file taxes? Chiang says it costs all of $125,000 a year to maintain the software. That's cheap!
If you're fed up with corporations that make millions off tax prep software and then use that money to try to destroy free, government supported alternatives, don't buy Intuit's TurboTax or Intuit's Quicken.
Also, if you do buy a competing tax prep program, don't buy the state version. Just use Ready Return.
Alternatives to Intuit TurboTax
Intuit's response to criticisms.
I found their essay long and full of smoke. They tried their best to include some scare stories, but they were vapor, in my opinion. The existence of Ready Return and CalFile doesn't preclude Intuit or anyone else from creating the State version of the filing software. All it does is compete with the commercial software. There's nothing wrong with a free "public option" that's available not only to low-income people, but to all people. Everyone paid for it, so everyone can use it. Enjoy.
Form 1099 is an information form, submitted to the IRS, telling them that a company paid a contractor some money for services.
Often, a company will distinguish between employees and contractors by calling them W-2 or "1099".
Workers may talk of doing "1099" work, meaning working as a contractor instead of as an employee.
There are numerous different types of 1099 forms for different transactions that result in income to a person. Generally, the amounts on the 1099 forms are added to your income.
Tax form W-2 is a statement of earnings. Your employer will send you one in January, and you use it to fill out your taxes.
There are W-2 forms for different kinds of income, but the most common is for wages and salaries.
W-2 is often contrasted with Form 1099, the income information form.
Your "gross income" is all the money you've earned in wages or salary, received as interest, gifts and prizes. Basically, anything you got in some form of cash. (It doesn't include things like increases in the value of property, or stock options.)
For tax purposes, you are allowed to deduct a standard amount of money for personal living expenses, some kinds of interest, and some other expenses. After subtracting these from your gross income, the result is your adjusted gross income or AGI.
You pay taxes on your adjusted gross income. This value is used to calculate how much you owe in taxes.
After calculating your AGI, you can take additional itemized deductions.
To qualify for Free File, your AGI must be less than some set amount (in 2009, it was $57,000). Because your AGI is calculated by subtracting some deductions, like mortgage interest, your gross income could be substantially higher than the maximum. If your gross income was less than $70,000, you are probably eligible to use Free File.
The earned income tax credit (EITC) is a great deal for low-to-moderate income workers. For single workers, the credit is below $500, but for dual or single parent families with children, the EITC can help eliminate up to $5,600 of your taxes.
The IRS has a EITC Home Page where they tell you how much you can get, and how to get it.
The idea behind the EITC is to reward people who work. Specifically, they are trying the hardest to relieve taxes for someone who has to work a moderate-income job, and raise kids. If you make under $22 an hour, and have children, you may not have to pay taxes at all, because of the EITC.
The state of California requires that employers notify potentially eligible workers of this fact.
Low Income Taxpayer Clinics are an IRS service where people will help you fill your taxes. Click the link and find your nearest location.
Also, pay attention to community websites and civic news. The IRS has tax workshops for people learning how to do taxes. There are even events where the IRS shows you how to get the EITC.
Wikipedia has a good article describing why EITC works better than welfare when the goal is to get people working.
Tax deductions fall into two broad categories: the ones taken before calculating your adjusted gross income (AGI), and those taken after.
The second kind are called itemized deductions.
Itemized deductions include things like: money spent for supplies for work that weren't reimbursed (like teachers buying school supplies); medical expenses; state and local taxes paid; mortgage interest; gambling losses; donations.
"Taking a deduction" doesn't mean that the government gives you back the money you spent. (That would be a tax credit.) A deduction subtracts from your AGI, so, you pay less taxes.
The one problem with taking deductions is that many deductions are only for expenses greater than some percentage of your AGI. Usually, the threshold's something like 2%.
Suppose you had an AGI of $20,000. 2% of that it $400. To take a deduction for a category of expenses, you must spend more than $400 on that category of expenses. So, if you wanted to deduct your driving for work, it has to exceed $400 (or around 200 miles). The first $400 of that expense comes right out of your pocket! (Lesson: get reimbursed.)
Now, if your AGI is $40,000 (aka, a solidly middle class income), that AGI threshold is now $800.
Also, note that the threshold applies to an entire category of expenses, not all your expenses in total. So, you can spend $100 on driving, $200 on gambling, $1,000 in medical expenses, and have $500 in stolen property, and still not hit the lower threshold.
There are also upper limits to deductions... but generally, most people have problems even deducting things in the first place.
Generally, deductions have value to middle-income to high-income wage earners. If you're earning less than the median, you probably can't take many deductions, mainly because you're not going to be spending so much money on deductible expenses.
If you're seriously looking at taking deductions on education or medical expenses, consider getting tax exempt savings accounts.
The terms progressive tax and regressive tax describe taxes that affect different levels of income differently. They don't refer to political ideology.
A progressive tax is one that taxes high wage earners more than low wage earners.
A regressive tax is one that taxes low wage earners more than high wage earners.
A flat tax is one that taxes everyone equally.
In the following examples, I describe people as "poor" or "rich" to increase the contrast between the types of taxes.
Examples of progressive taxes:
Income taxes. The more you earn, the more your income is taxed. Right now, the tax rate ranges between 10% and 38%, with the highest paid people paying the 38% rate. Of course, they pay 38% only on a fraction of their earnings, which is normal for a progressive tax. See tax brackets for clarification.
Capital gains taxes. Though this is generally a flat tax, it's wealthy people who tend to have the most capital gains, because they own more assets.
Examples of regressive taxes:
Sales taxes: poor people buy things, and save almost nothing, thus most of their income is taxed. Rich people buy things, maybe more things, but save a lot of money (or invest it), and that saved money is not subject to sales tax. Poor people end up paying more of their income in taxes.
Parcel taxes: poor people who live on small parcels pay the same as rich people who live on large parcels.
The "flat tax"
It's actually difficult to create a flat tax. The sales tax is nominally a flat tax, but in reality, it operates in a regressive way.
The typical flat tax proposed by politicians usually includes a large exemption from taxes for income below a certain amount, like $20,000. So, it really starts out as a progressive tax.
Then, there's a range in there where the tax really is flat. As income rise, however, there are ways to avoid taking your pay as "income", usually through benefits and stock options. Since that tax is now dodged, the flat tax is no longer really flat.
It's progressive for the poor, and regressive for the rich.
When someone works as an independent contractor or on odd jobs, they have to pay self-employment tax in addition to regular income tax.
The self-employment tax is basically Medicare and Social Security tax payments. It is currently 15.3% (in 2009).
Regular employees have their Medicare and Social Security paid by their employer. A self-employed person has to pay for these things on their own.
If you're self-employed, you need to always figure in the self-employment tax into your hourly rate.
The progressive income tax divides your income into ranges, called brackets.
Income within a bracket is taxed at one rate. Income past a certain amount is taxed in a higher bracket at a higher rate. There may be multiple brackets. Consider the following example of tax brackets:
| bracket | tax rate |
|---|---|
| $1 - $10,000 | 10% |
| $10,001 - $20,000 | 20% |
| $20,001+ | 30% |
If you make $30,000, you are said to be in the highest tax bracket, paying 30% in taxes.
That doesn't mean you're paying 30% of your income (or $9,000) in taxes. Many people have that misunderstanding.
What it means is that the highest rate you're paying is 30%.
For your income from 10,001 to 20,000, you're paying 20%. For your income from 1 to 10,000, you're paying 10%. Let's do the actual math.
| bracket | tax rate | tax paid |
|---|---|---|
| $1 - $10,000 | 10% | $1,000 |
| $10,001 - $20,000 | 20% | $2,000 |
| $20,001 - $30,000 | 30% | $3,000 |
Add them up, and the total is $6,000. (Which works out to 20% in tax.)
Some people will say that "the first dollar you earn is taxed at the lowest rate" and "the last dollar you earn is taxed at the highest rate". This is factually true, but, tends to confuse beginners. So it's not much of a simplifcation.
For actual tax brackets, see the Wikipedia article or the IRS.
The actual tax brackets are 10% all the way to 35%, and the 35% rate doesn't affect anyone earning less than $372,000 a year.
Most people are in the 25% bracket or below. The 25% bracket goes up into the $80,000 per year range.
A tax credit is money that's given to you for spending your money in a specific way, or belonging to a specific category of taxpayer.
For example, renters in California get a "renter's tax credit", which is a small amount of money you get for being a renter.
Parents get a Child Tax Credit of $1,000.
Another well known tax credit is the "earned income tax credit" or EITC, where people who work, but don't earn very much money, are given some money. The less you earn, the larger your credit. (Click EITC to learn more.)
The largest popular credit today (in 2010) is the first time homebuyer credit, which pays you $8,000 for buying a new house, if you haven't lived in a house in the past three years.
A tax credit is not a tax deduction. It is much better, because a credit's money in your pocket.
For some math to explain this, see Comparing a Tax Credit with a Tax Deduction.
A tax-exempt savings account is just like a savings account at a bank, except that any money put into it isn't taxed, and the money can be spent only for specific, eligible expenses.
Tax exemption is like an itemized deduction except better, because you get the tax savings immediately. Deductions, as noted in the linked article, generally can be taken only after the expenses exceed a specific amount. Tax-exempt savings take effect immediately.
Some negatives of tax-exempt savings are:
There are many different types of savings plans, so they'll just be listed, not described:
Retirement savings: IRA, Roth IRA, SIMPLE IRA, 401(k), 403(b), 457
Medical savings: FSA, HSA
Education savings: 529, Coverdell ESA
When you go to the drug store, you get a receipt with a little extra info about "Flexible Spending Account (FSA)" expenses, for specific items. You save these receipts, and total the FSA-eligible amounts, and find that you spend $300 a year on this stuff.
Your employer offers an FSA plan, so you sign up and start putting $20 per month into the account. You want to keep the amount below expected expenses, because FSAs have a "use it or lose it" rule, where you lose the money if you don't spend it.
So, during the year, you put in $240, and spend the whole $240. (You spend it by using an ATM card to pay for expenses at the drug store.) How much do you save?
It depends on your income tax bracket. Suppose you pay income taxes at the 20% rate. The question to ask is, "what would you have to earn to pay for $240 of expenses?".
The answer is $300.
So, instead of having to earn $300, you only had to earn $240. That's a $60 savings.
The savings changes drastically if you're in a higher tax bracket (wealthier people benefit more), and if you have a chronic illness.
If you have $4,000 of annual expenses, and are in the 25% tax bracket, your annual savings is around $1,300.
By and large, tax-exempt savings work if you're a middle income person (earning over $30,000) in a job with a fairly large employer. You'll have money to save, skills to deal with paperwork or access to someone who can help, and access to all the plans.
These plans are a big benefit to wealthy people, as well, because they can act like long-term insurance plans. You can save money for years, and spend it when you're old.
They really don't work out for poor people, because poor people generally lack savings, and need their savings to be flexible to deal with emergencies. They also tend to not have access to the plans, if they work in small businesses.
As you may have guessed, these savings plans are favored by Republicans. So if you're poor and a Republican, and voted that way in the past, consider this when you're voting next time. These savings plans end up costing the government tax revenue that could be used to pay for social services that everyone could use.