Taxes is a topic that affects us young and old – whether we are worrying about how much taxes to pay if you win the lottery or buying your first item as a kid for $10.00 and realizing sales tax is a thing and it truly costs more than $10.00. While taxes do serve a vital function to our government and the beautifully smooth roads we all enjoy, and perfectly executed legal system dispensing justice and creating laws that bring no controversy or discord whatsoever… As with any topic, often learning and understanding a thing a little better helps calm nerves and lends to better decision making (us non-politicians at least).
So boomers, zoomers, millennials, gen z, gen y, and all the other names we use as labels can be set aside as we all can learn something that either helps us personally – or someone we know and care about. The focus of this article will be taxes for those in their younger years, thus the writing style will be more toned for this audience.
How do tax brackets work?
The very first concept to learn about is tax brackets and to resolve one mental optical illusion that is common to many folks. There is no spoon… Ok well I’m fairly sure we aren’t all taking part of a procedurally generated fantasy world (Matrix movie reference) the real thing I mean to convey is that our tax system is a progressive tax system not a one size fits all system. The more money you make the larger portion of your income is subject to tax, but it is NOT retroactive. The first dollars made are taxed at 10%.. But if you do actually end up winning the lottery and end up in the highest tax bracket (as of this writing that is 37%) while a large portion of your earnings will carry 37%, you still have those first few dollars taxed at 10%, and always will. Meaning crossing a tax bracket does NOT – and if you are reading this I would humbly suggest you say this phrase out loud – literally.. I want others to question what you are reading because they might need to hear it too “my tax bracket does NOT mean all my money is taxed the same way”.
If I make more money does this mean I pay more in taxes?
What does that mean though? Honestly, I have met a fair amount of folks who are very afraid of making too much money, thinking that if they cross a tax bracket (say from 24% to 32%) by taking a raise or promotion that they will end up with so much more tax due to their new income, and by being in a ‘new tax bracket’ that they will end up paying more in taxes after their raise or promotion offered. This doesn’t happen and the tax brackets do not function like that. I have a joke that I have repeated to many folks and it goes something like this, “if you are EVER concerned with having so much income that you are upset at how much tax you have to pay, you can give all the money to me and I will pay the tax for you – it is a selfless, kind, volunteer solution I offer freely to anyone.” And you know what? Not one single person has ever taken me up on it! I can’t puzzle out why. It paints the picture though, you always end up with more in the bank account even after taxes than before. Please never be afraid of making too much money for tax reasons. It is a good problem to have. You do want to ensure you are paying the lowest amount of taxes legally due, but don’t lower your income to avoid paying extra taxes.
Your First Paycheck: Taxes?!?!
The next big topic is taxes in your very early years. First the easy, then the not so easy. The easy one is working for an employer as an employee. You get paychecks that take out taxes and your expectations and work shifts are fairly clear. The second is working contract or for cash. It seems contrary that the cash option is the more complex one, but it comes down to how a tax return is designed.
With the first option, you are a W2 employee. Your employer pays a portion of taxes and you pay a portion of taxes. With the second option, you are considered a 1099 contractor, or self employed. This means that you are responsible for paying BOTH the employer and the employee portions of taxes. This is very, very simplified, but it is absolutely imperative to understand. I’ll go into this a little more below.
With the second option, you are able to take work deductions against your income. With the first, you generally are not able to. However, with both W2 and 1099, the IRS grants a set limit every year that essentially cuts off a portion of your income that they say you don’t have to pay taxes on.
How does the Standard deduction work?
This is called the standard deduction. I know math generally is not fun for most folks but work with me here for a brief moment. If your standard deduction or “free deduction” from the IRS is a bigger number than all your income, then you legally have 0 income to be taxed on because all of your income got deducted. Here is an example: a 22 year old working at chick-fil-a and still in college full time. They make $5,000 that year – and the current standard deduction as of this writing for a single person is more than $12,000. So $12,000 minus $5,000 is less than $0.00. Guess what 10% of $0 is? ZERO. Guess what 37% of $0 is? Zero. You owe no taxes to the IRS for your income.
Self Employment Taxes are Separate from Federal Taxes
Social security and Medicare is a different story. If you are an employee with paychecks that take out taxes this is done for you on every paycheck and you don’t have to think about it or worry about paying it all in one lump on your tax return. Thus – ‘easy’ because your tax burden can be zero.
When you are working cash or contract this is a big problem for you. The big problem is that after you calculate your IRS tax, you then add ‘other’ taxes. One of those other taxes is what is called self employment tax – which is essentially the social security and Medicare tax that you never paid. What that means is that if you are 16 or 96 and you have cash / contract income that is less than the standard deduction – you may not think you have to pay any taxes, but your tax return will still show a balance due. This doesn’t mean that self employed work is bad, it is simply that zero taxes of any kind were ever paid. An employee pays taxes every single paycheck. Add that up across an entire year, it ends up being a larger number than you might realize. Doing dishes daily is very different than doing an entire month’s worth of dishes in one night. You can certainly plan your Sunday around it and there technically isn’t any difference in time spent when added all together, but the perception of time spent (or dollars paid) is certainly very different.
The takeaway and cautionary tale here is that if you are not paid as an employee where they take taxes out automatically – you will likely owe money when you file your tax return, and you might consider hiring a professional to help you pay the least amount of tax.
It isn’t all terrible, and if you are contract there are deductions you can take to help you pay less IRS tax and self employment taxes. Consider how popular the gig economy is – Uber, door dash, insta cart, and a myriad of other ones. All are cash/contract jobs. This is really important to know – for you personally, or for you concerned others who are helping raise those doing this work. Even the simple idea of using miles to help reduce your tax bill is important to capture on a tax return. The more deductions or “write offs” you use against this contract/1099 income, the less money you have to pay in taxes because it shows the IRS you have less income. Examples of these types of deductions vary based on which job you are doing and which industry you are in, but a few common ones are: vehicle mileage, training or education expenses, internet and cell phone, office supplies, marketing expenses, etc. Be sure to not confuse business deductions with the standard deduction!
Here are a couple of other resources we have for self employed folks: https://molentax.com/self-employed-resources/
Do I need to file a tax return?
The last topic to touch on is does person X need to file a tax return? Let’s go back to our example of $5,000 dollars earned. For the employee, they have $0 federal tax and $0 self employment ‘other’ tax because the employer took care of it for them during the year. Thus if you are young and know that your income is very low, you could either ensure that your employer takes out the most federal taxes so you have a refund each year and get into good habits of filing each year…. or you could put EXEMPT on the W4 you have to fill out when starting a job, then they would take out 0 IRS taxes (they will still take out social security and Medicare) but then if your income after the standard deduction does fall under the 0 mark, you (or your caregivers) don’t need to be bother filing a tax return! I personally think there is value to building good habits and filing each year is the ‘right’ choice, but it isn’t the only choice and I would be remiss to not at least offer an alternative.
However, in the same situation of $5,000 earned but this time as self employed income, even if you take $4,000 in business expenses and only have $1,000 in taxable profit – you still have to file a tax return no matter what, and you will have a VERY high chance of owing money to the IRS.
To close in younger generation terms:
Tax brackets are not retroactive
Don’t ever be afraid of making too much for tax reasons
You ‘may’ not have to even file while a teen or in college IF you are an employee
If you are not an employee or work gig economy (1099 cash or contract) – you most likely will owe taxes and seek professional guidance
If you haven’t seen The Matrix you are missing too many good references and jokes, fix it.