I think we can all agree that learning about parallelograms and chlorophyll instead of how to file our tax returns was a mistake.
Perhaps one day, personal income tax will find its way into the curriculum, but until then it’s probably up to parents to help kids understand how it works.
When dealing with all financial topics, the goal is awareness and practical understanding. Using simple explanations go a long way to making the information actually “stick.” Incorporating practical exercises is even better.
This post is designed to help you get a deeper understanding on taxes so you can help your kids understand how they work.
Here’s what we’ll cover:
- What are taxes?
- Different kinds of taxes
- Filing your taxes
- How do tax rates change
- When to start?
Let’s get started.
What are taxes?
Taxes are contributions in the form of money paid by people and companies to the government. An organization called the IRS (Internal Revenue Service) collects the money and gives it to the government.
What does the government do with the money?
Every year, the government creates a budget just like a family does. This is their plan for spending the taxes they take in. The money is used to pay for programs such as:
- Healthcare which accounts for around 25%
- Social Security which accounts for around 23%
- Defense and security which accounts for around 16%
- Social safety net programs account for around 9%
- Debt repayment accounts for around 8%
These programs are what we’ve decided are the top priorities for us to focus and spend money on.
What if we don’t pay taxes?
Everyyear, around April 15th, we’re expected to file our tax returns. It’s a form that helps you figure out how much money you owe in taxes, or if you’ve already paid enough taxes for the year. In some cases, you may even get money refunded back because you’ve paid too much in taxes.
If you don’t file your tax forms, and don’t pay taxes you owe, you’ll get in trouble. You’ll be charged penalties and interest on the amount you owe. In extreme cases, you may even go to jail.
It’s important to pay close attention to your taxes, file your return on time, and pay any taxes you owe.
Different kinds of taxes
As you no doubt know, there are a lot of different kinds of taxes.
Payroll tax and Federal income tax withholding
What happens when you get a paycheck? Taxes happen. We pay federal income, Social Security, Medicare, and federal unemployment tax through our income, before the money makes its way from our employer to our bank accounts.
The idea is to pay your taxes a little bit at a time throughout the year instead of waiting to pay all of them all at once. Your employer is responsible for taking the taxes you owe from your pay and sending it to the IRS.
Form W4 helps employers figure out how much they need to take out. The good news is this form is normally pretty straightforward for a teenager. Assuming they are single with no kids of their own, they’ll only need to fill out step 1.
Sales tax
Sales taxes are a type of consumption tax, meaning you pay tax on certain things when you buy them. Commonly, we pay sales tax on most things we buy, with the exception of groceries and clothes. Also, sales taxes vary state by state.
The taxes are an indirect tax, meaning they are collected by the company you’re buying the item from, and then sent to the local or state government. Sales taxes are make up the largest source of revenue for states. The federal government does not collect sales tax.
The next time you buy something, you can use the receipt as a learning opportunity to go through with your kids.
Property tax
Property taxes are assessed on the value of the land and structures on the land. So, you pay tax on the value of your lot as well as your house and any additional structures on your lot.
These are state and local taxes, and the amount you pay depends on the state you live in. New Jersey has the highest tax rate at 2.49%. Therefore, if you live there and the value of your house and property is $100,000, you’ll pay $2,490 in property tax annually.
Capital gains tax
We pay capital gains taxes on money we make from investments. For example, if you bought shares of Apple stock at $50 a share, and sold them at $100, your gain would be $50 per share. You’d pay capital gains tax on the $50 profit you made.
The rate you pay depends on your income, so you’ll determine how much you owe when you’re completing your tax return.
There are also two different types of capital gains taxes:
Short-term. You pay short-term capital gains on profits if you’ve owned the asset for less than one year. The rate is essentially you’re ordinary income tax rate.
Long-term. You pay long-term capital gains on profits if you’ve owned the asset for more than one year. This rate is normally less than you’re ordinary income tax rate.
Filing your taxes
Every year around April 15th, our income taxes are due. Learning how to file a tax return is a valuable skill to have, one many of us wish we had learned in school. Here are the steps for making it happen.
Step 1. Get organized
Around the first of the year, you’ll start to receive important tax documents in the mail. Fortunately, they are normally labeled with something like “important tax documents” so we don’t discard them.
Keep an eye out for form W2s and 1099s. It’s also important to gather receipts for charitable donations and medical and business expenses if you intend to itemize your return.
Step 2. Determine your filing status
The five filing statuses are single, married filing jointly, married filing separately, head of household, and qualifying widow(er) with dependent child.
Step 3. Figure out how you’ll file
The best and most common way to file our taxes is to do it electronically through efile. You can do it yourself, or you can purchase a software program to help you do it.
Step 4. Decide on taking the standard deduction or itemizing
As you’re calculating your income tax liability, you’re able to deduct certain expenses from the amount you owe. These range from mortgage interest, child tax credits, student loan interest, charitable contributions and many more. You can add up all these expenses, known as itemizing your deductions, and subtract the total from the amount of taxes you owe.
In an effort to simplify this process, the government increased the standard deduction from $6,500 to $12,000 for individual filers, from $13,000 to $24,000 for joint returns, and from $9,550 to $18,000 for heads of household in 2018.
Let’s use an example. If you’re single and file your taxes as an individual, and your itemized deductions total $10,000, you’re better off to use the standard deduction of $12,000.
If, on the other hand, your itemized deductions total $30,000, you’re better off using those deductions and not utilizing the standard deduction.
Step 5. Determine your tax liability
You’re almost done, and you’ve determined you owe the IRS money in taxes. You can pay the full amount when you file your taxes, or you’re able to set up a payment play.
For example if you owe $12,000 in taxes, the IRS will work with you to pay off your debt at whatever frequency is possible for you. They are very accommodating and willing to work with you. The important thing is to be proactive and communicative with them.
Step 6. File your taxes
Beginning around the middle of January, you’re able to begin filing your tax return. Around April 15th is the tax return deadline, meaning you need to file your return by this date, or request an extension.
Should you find yourself needing more time, you can file an extension which will give you until around October 15th to file your taxes. Keep in mind, if you owe the IRS money, you’ll need to make the payment or set up your payment plan by April 15th. If you don’t you may be subject to fines and penalties.
I can’t stress enough how important it is to establish a clear and open line of communication with the IRS. If you’re confused about something, or need help, they have excellent customer service and a very helpful website.
How do tax rates change?
As your kids begin personally paying taxes, they may begin to formulate opinions (positive or negative) about them. Federal income tax brackets and tax rates are changed by creating a new law.
Like every law change, a bill is proposed in the Congress. A bill commonly introduced in the House of Representatives and is voted on. If it is approved, it moves to the Senate and is again voted on. If approved, the bill is sent to the President. When the President signs the bill, it becomes law.
Therefore, if you’re unhappy with the current tax laws, you can reach out to your Congresspeople and express your thoughts directly to them. They are your voice in the government and always enjoy hearing from their constituents.
When to start?
Involve your kids in your taxes. However you prepare yours, let them be a part of it.
Once kids are five and up, they’re commonly able to start learning about taxes like sales tax.
When kids are 12 and up, they’re ready to start learning about income tax, Social Security tax, and all the other taxes taken out of a paycheck. This is particularly true if they’re working outside of the home and experiencing that bite first hand.
Like most other aspects of money and personal finance, helping your kids to understand taxes starts with your intention. If you want to help your kids, and you do your best, you’re off to a great start. There’s no right or wrong way to do it.
I take that last part back; if you do nothing, that’s the wrong way to do it.
It’s also essential for you to do everything you can to set a positive example. Getting your personal financial situation as strong as possible will give evidence to your kids that it’s possible to be successful with money.
You’re someone who can raise financially literate, responsible and successful kids!
If you’d like to help your kids get good with money, check out our Teaching Kids about Money course.
If you’re ready to take control of your financial life, check out our DIY Financial Plan course.
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