How Do Taxes Work? Don’t Evade Tax Knowledge!

How do taxes work?

Few of us have even a basic understanding of the U.S. tax system. Understanding taxes is something most of us put off until, well forever. We believe it is easier to hire someone to file our annual income tax returns. Depending on the complexity, paying for tax return preparation can absolutely be justifiable. But filing our taxes once a year is not the only time tax knowledge and tax strategy come into play.

When creating wealth, our understanding of how taxes work can prove extremely beneficial. Our lack of knowing how taxes work can cost a great deal.

You may know how to do your taxes if it were just for your normal W-2 income every year, but what if you decided to invest in rental properties or pursue entreprenership with side hustles to make extra money? Nearly every major decision we make around finances has unique tax implications.

How can we make the best decisions if we don’t know the answer to how do taxes work?

What if instead of assuming misfortune when the subject of taxes surfaced, you saw opportunity? Opportunity to expand on your collection of skills and knowledge. Opportunity to understand and make the most of the rules. Opportunity to keep more of your hard-earned money, and increase your freedom and flexibility in life.

Does this sound far fetched?

It sounded strange to me just a few years ago. But after seeing dozens of people from all walks of life making incredible progress on their finances, largely due to their understanding of the U.S. tax system, I decided to embrace taxes. Reading and making an effort to understand how taxes work, and then taking action and applying my newly acquired tax knowledge paid off immediately.

This lesson is meant to answer the question, “How do taxes work?” and serve as the foundation of your tax knowledge. You’ll find it insightful, not as intimidating as you thought, and financially rewarding.

Fiology thanks Juan of Finance Clever, a tax expert of the FI community, for shaping this lesson.

Read:

• A Basic Overview of the U.S. Tax System  by Juan of financeclever.com
• Effective Tax Rates: How Much You Really Pay in Taxes  by Robert Farrington of thecollegeinvestor.com
• Section 199A for Beginners  by Sean Mullaney of fitaxguy.com

Watch:

• Basics of US income tax rate schedule | Taxes | Finance & Capital Markets | Khan Academy  by Khan Academy of YouTube

Take Action:

1. Pull up your most recently filed tax return. If you are not sure how to do that, here are some ideas. If you used a DIY tax software such as Turbotax, you can access your tax return by logging into your account. If you used a CPA or tax preparer you can ask them for a copy.
2. Once you have your tax return handy, take a look at your sources of income, your adjusted gross income (AGI) and how much your ended up paying in taxes. From there, use the knowledge you have acquired and look for ways to reduce your tax liability going forward. Can you increase your contributions to your retirement accounts? What about a health savings account (HSA), or a flexible spending account (FSA)?

Additional Resources:

• Never Pay Taxes Again  by Jeremy from gocurrycracker.com
• Retire Even Earlier Without Earning More or Spending Less  by Brandon of madfientist.com
• Tax-efficient fund placement  of bogleheads.org

Quote:

“Thinking is one thing no one has ever been able to tax.” – Charles Kettering