Let’s talk taxes, deductions, and other tax terms!

During tax season, deductions get loads of scrutiny. What is a deduction? And do I qualify for this deduction or that one? Can I deduct the amount of money I spend on coffee every morning? -probably not.

For some people, the talk of taxes makes their eyes glaze over like a fresh doughnut (Can you tell what I’m craving?).

I promise that I’ll try to make this more interesting. But just as a warning, taxes can be boring.

Anyway, you should be gathering all your paperwork from last year. You know, your W-2s, and 1099s, to file your 1040 schedule this or that.

I’m sure I’ve already lost some of you. Either due to boredom or just indifference.

But, in my opinion, everyone should know and understand how taxes work. You may not know all the ins and outs, but a little knowledge can help you minimize your tax bill and maximize the money you keep in your pocket. And I’m all for keeping more of my money!!

So let’s get started.

First of all, your employer reports your income to the IRS, and they also withhold money from your paychecks for taxes. So, if you decide that you don’t want to file taxes, rest assured that the IRS does know about you, and they will get their money – one way or another. It may take years, but the IRS is not a creditor that you want harassing you! So make sure that you file!!

Filing Status

There are several “ways” to file. They vary depending on your specific situation.

You can file as “single” if you aren’t married or are divorced.

If you’re married you can file either as “married filing jointly”, which means you file one return for both of you, or as “married filing separately”, which means you file two returns instead of one.

You could also file as “head of household” or “qualifying widow(er)” in other situations.

Gross Income and Taxable Income

Any income you make needs to be reported. Whether that’s interest on savings accounts or money from other jobs. In most cases it’s already reported, you just have to fess up and report it as well. It’s kinda like when your Mom asked you who broke the lamp, and you’re an only child with no pets. She knew it was you, she just wanted you to fess up.

The total amount of income you report is called your gross income. Then there’s loads of things that can deducted from your gross income. Things like health savings account contributions, some student loan interest, some retirement account contributions, and perhaps some business expenses. What’s left is called your adjusted gross income, or AGI for short.

Are you feeling smart yet?

Next you add up all your exemptions and deductions and subtract them from your AGI. This is your taxable income. This is where it gets complicated.

Exemptions

You can claim exemptions based on the people living with you and who you support. For instance, a single Mom with two kids would claim three exemptions.

And a married couple with one kid would also claim three exemptions.

For the 2017 tax year, one exemption was $4050. Multiply this amount by the number of exemptions you claim and subtract it from your AGI.

Deductions

First, there are two different paths here. You could take either the standard deduction or you can itemize (add together) all the deductions for which you qualify. You can’t do both!!

So, you would add up all the deductions that you qualify for, and compare that amount to the standard deduction. And obviously, you would deduct the higher amount from your AGI.

After you deduct all your exemptions and either the standard deduction or your itemized deductions, this becomes your taxable income.

Tax Liability

The easiest way to calculate your tax bill is to look up your taxable income in the IRS tax tables and note your tax. And don’t worry, it’s not as complicated as it sounds. You simply find your taxable income on the column on the left, and then look across to see what your tax is. It’ll probably vary depending on your filing status. Easy-peasy.

That’s it – you’re done. Well, not quite. You still have to actually enter all that info in the right forms and such. I would recommend using Turbotax or H&R Block online. I’ve used Turbotax the last couple years.

Minimizing Your Tax Liability

This is the fun part. Well, maybe not fun like riding a roller-coaster or even watching a movie. But it is fun to save money.

There are many deductions that you could take to lower your taxable income. Some are more obscure than others, and you and I may or may  not qualify for them. From moving expenses to childcare expenses to property taxes, the situations they cover are vast.

I don’t have enough time or space to discuss even half of the deductions available. And they will change with the tax reform bill that was recently passed.

Mortgage Interest Deduction

One of the most popular deductions (which will still be available next tax season) is the mortgage interest deduction. This deduction allows you to deduct from your taxable income the amount of interest you paid to the mortgage company that year.

But there’s some mis-information out there regarding this deduction.

I’ve heard several people say that you should not pay your mortgage early because you need it to take the mortgage interest tax deduction. Which is true . . . but . . . let’s explore this mortgage interest deduction for a few moments.

Mortgage Interest Deduction Illustration

Let’s say you were in your second year of a $150,000.00 mortgage loan. Let’s also assume an interest rate of 3.875% and a 30 year term. If your mortgage is different – loan amount, interest rate, or term – the numbers will be slightly different, but the conclusions will be the same.

Using the above numbers, you would pay approximately $5,765 in interest to the bank in this second year. This is also the same amount of money you would enter on your tax forms as a deduction.

The taxes you save on your bill by taking this deduction are calculated by multiplying the amount of the deduction (in this case – interest) by the tax rate. Your tax rate will vary by income. For example, if your tax rate was 25%: $5,765 x 25% = $1,441. This is the amount you save on your tax bill.

So in other words – If you had no mortgage, your taxes increase by $1441, but with a mortgage you pay the bank $5765.

So, you pay $5,765 to the bank in order to not pay the government $1,441. Think about that for a minute. Does that really make sense to you?

No matter what the numbers of your loan are, the result will always be the same. The tax bill savings is less than amount of interest paid.

By all means – take advantage of the deduction, but the bottom-line is: don’t worry about keeping a mortgage around simply to take the tax deduction. Pay your mortgage off as soon as you can – once your other debts are gone of course.

Charitable Giving

This is another popular deduction. What you give to a qualifying charitable organization (think: church, not-for-profit, or Goodwill) can be deducted from your taxable income.

Just make sure you keep records of you donations in case you are ever audited. Taking this deduction raises your audit risk simply because of how easy it is to fabricate your giving.

In this world nothing can be said to be certain, except death and taxes. - Benjamin Franklin Click To Tweet

Conclusions

Are you still with me, or are you asleep?

Now that you know the basics of taxes, rest assured that you don’t have to actually remember all this info. If you do your taxes online, most of the software will walk you through this info. It really isn’t that hard.

And remember, you can save tons of money by doing your taxes yourself. Especially if you don’t qualify for many deductions or you take the standard deduction.

So, don’t feel intimidated by taxes. You can do it!!

For even more tax deduction reading, check out this article on Forbes.

Do you file your own taxes? How complicated is your tax situation?

Let me know in the comments and thanks for sharing and reading.

Author

Chris is the original Cash Dad. He's a father of 3 and a mechanical engineer by trade.

2 Comments

  1. Yeah, I am glad that you handle the taxes on our family. I read it but once you mentioned that freshly glazed donut you pretty much lost me. ?
    Love you,
    Kate

    • Chris Reply

      Haha, I thought I would probably lose at least one . . . At least you have me to do your taxes for you. ?

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