10 Essential Facts About Federal Income Taxes

Albert Tercero

En español

It’s right there on most every store receipt, pay stub and monthly mortgage statement: a notice of how much of your money went toward taxes. America’s complex, multitiered tax system means that handing over money to the government is perpetually in your face and on your mind, and never more so than as Tax Day approaches each spring.​ ​

But do taxes have an outsize grip on our imaginations? After all, can you really do much about them? (Spoiler: In most cases, no — as Benjamin Franklin hinted 200-plus years ago.) “I think people either obsess about taxes or they ignore them completely,” says Sallie Mullins Thompson, a CPA who works in the New York City area.​ ​

Thoughtful tax planning and a careful accounting of what you owe every year are crucial parts of overall money management. But beyond that, perhaps you should simply not worry quite so much about taxes. As these 10 truths about taxes illustrate, the right way to think about them comes down to keeping them in perspective.​ ​

​1. You may fret about taxes more than you should ​ ​

Your ability to control your tax bill is more limited than you may think. Take income taxes: You may earn money in various ways — perhaps from a job, a side gig or investments — but the taxes you pay on each are defined by hard-and-fast rules.​

​“Everyone is afraid of missing a silver bullet that will reduce their taxes. For most people, those don’t exist,” says Tim Steffen, director of tax planning at the financial services company Baird. If you’re a middle-class homeowner without squads of lawyers, you pay many types of taxes — sales, income, property, “sin” and beyond. You have the most leeway over your property tax bill. The rest are mostly out of your control.​

2. … and, no, the IRS isn’t out to get you.​

​The agency is beset by problems: delays in processing returns, not enough staff to answer the phone and insufficient funding to conduct audits. That last part means you’re less likely than ever to face an audit; fewer than half a percent of returns were audited in 2020.​

​And any challenge will probably come in the form of a letter, not by IRS agents knocking at your door in suits and sunglasses. “People forget that when the IRS talks about audits, that’s a very broad term,” observes Mark Luscombe, federal principal analyst for Wolters Kluwer Tax & Accounting. ​

​Often the IRS simply needs more documentation. (Send it.) If you get a notice from the IRS claiming you made a mistake on your return, you can challenge it. Any letter will have instructions on handling disputes. Sometimes the IRS may even find an error that goes in your favor and delivers a bigger refund than you expected.​

3. If you earn your money the old-fashioned way — with a salary — saving is your best tax-cutting option … ​

For all those years when you’re collecting a paycheck, you have just a few levers you can pull to meaningfully reduce your tax bill. The best of them are 401(k)s, 403(b)s and IRAs — accounts that let you set aside large chunks of earnings for the future without having to pay taxes on them first, or as they grow in value. Yes, you’ll have to pay taxes on them someday, but often at a lower rate than you’re paying now. In 2022 you can contribute up to $27,000 to a 401(k) or 403(b) if you’re 50 or older; up to $7,000 to an IRA; or both. ​ ​

A Health Savings Account (HSA) is another useful tax-planning tool. It offers triple tax benefits: You don’t have to pay taxes on the money you put in, the account grows tax-free, and withdrawals are tax-free, too, as long as you use the money for qualified medical expenses. You can fund an HSA only if you have a high-deductible health insurance plan, which is increasingly common; 58 percent of people offered health insurance at work have access to a high-deductible plan, according to the Kaiser Family Foundation. In 2022 you can contribute up to $3,650 to an HSA if you have an individual health plan; up to $7,300 if you have a family plan — plus another $1,000 if you’re 55 or older. ​ ​

4. … but making financial moves solely to lower your tax bill can lead you to make costly mistakes. ​ ​

A lot of financial professionals — both legitimate and less so — will latch on to your desire to avoid taxes, plus your wishful thinking, to sell you expensive and complicated products that promise to protect your money from the IRS. Watch out! Picking financial products for tax purposes does you no good if the investment is a dud. “When the pitch for an investment opportunity leads with the tax savings, it’s usually a bad idea,” says Scott Bishop, executive director of wealth solutions at Avidian in Houston. “Invest in something only if you would do so without the tax incentive.”​ ​

​5. The tax system is complex, and that’s by design.​ ​

The tax code has two purposes: to provide the government with the money it needs to operate and to create incentives for taxpayers to do certain things lawmakers would like them to do, such as save for retirement, pursue an education, give to charity or even buy an electric car. ​

Whether taxes really change behavior, however, is open to debate. Take the mortgage-interest deduction, which was meant to encourage people to buy a home by lowering their annual income taxes. Economists widely argue that all the policy did was inflate home prices. At the same time, a 2014 study by the Center for Retirement Research found that the higher retirement-plan contribution limits that kick in at age 50 lead to only slightly higher savings rates.​

​Effective or not for society, these kinds of targeted provisions are popular with legislators — and they aren’t going away. “Simplification is discussed a lot, but Congress is better at creating new programs than getting rid of old ones,” Luscombe points out.​ ​


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