Taxes are complicated, and understanding how they work can be just as complicated — so much so that many people end up hiring a CPA or a tax preparer or buy software to file their tax return.
Enlisting professional help and tools can make things much easier — you answer questions, the preparer puts the answers to those questions on a few sheets of paper, and by some sort of unseen magic the details you provide determine how much you pay to the Internal Revenue Service (IRS).
Because people don’t often learn how to file the paperwork on their own, many have trouble understanding taxes.
As a former tax preparation professional, I’ve received my fair share of strange questions over the years. It has led me to realize there are a number of misconceptions about how tax brackets, deductions, and more work.
Here are some of the biggest tax myths, debunked.
Tax Myth #1: Your Tax Bracket Is Your Tax Rate
I can’t tell you how many times I’ve heard someone say they aren’t working any more hours or overtime because it would put them in the next tax bracket.
While earning more money may put you in the next tax bracket, it doesn’t mean all of your income will be taxed at a higher rate.
The U.S. system is called a “marginal tax system.” This means that you’re taxed on your income in stages. For this example, the tax brackets for the 2020 tax year filings are as follows:
Tax Rates (for Single Individuals Only)
- $0 to $9,875 — 10 percent
- $9,876 to $40,125 — 12 percent
- $40,126 to $85,525 — 22 percent
- $85,526 to $163,300— 24 percent
- $163,301 to $207,350 — 32 percent
- $207,351 to $518,400 — 35 percent
- $518,401 and above — 37 percent
Using theoretical numbers, if you had $30,000 of taxable income in 2020, you would pay 10 percent on the first $9,875 and 12 percent on dollar 9,876 through dollar 40,125. If you earned $40,126, you’d pay 22 percent tax only on that one dollar over $40,125! You wouldn’t pay 22 percent in taxes on your entire income.
Tax Myth #2: Itemized Deductions Save Everyone a Ton of Money
For some reason, people seem to think that itemizing deductions means that you’re saving a lot of money on your taxes. And this may be true in some cases. But many who itemize deductions aren’t saving nearly as much money as they think they are.
When you itemize deductions on your tax return, you no longer get the standard deduction.
If your itemized deductions do not exceed your standard deduction by a lot, you won’t save much in taxes.
All that you’re saving is the difference between the standard deduction and the total of your itemized deductions. Plus, a deduction reduces only your taxable income — not your actual tax due. So if you’re in the 22-percent tax bracket, each dollar of deduction saves you only 22 cents in taxes paid.
In addition, due to the passage of the Tax Cuts and Jobs Act, many people may benefit more from using the standard deduction, rather than by itemizing. Make sure to review your information to see whether or not you still benefit from itemized deductions, rather than by using the increased standard deduction.
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Tax Myth #3: You Shouldn’t Pay Off Loans That Have Tax-Deductible Interest
I’ve heard several people argue that you shouldn’t pay off student loans or mortgages early because the interest is tax-deductible. But though there could be other legitimate arguments for not paying off these types of loans quickly, tax deductibility isn’t one of them.
As discussed above, a tax deduction lowers only your taxable income, not your tax due. So for every dollar in interest you pay, you save just a small portion. It usually comes out to 22 cents or less per dollar of interest you pay. While paying 78 cents is better than paying $1, paying nothing is better. Paying off your loan saves you 100 percent of the interest you were paying.
Did you know that many tax-saving opportunities are found outside your tax return, but still follow the same deadline?
There is still time to take advantage, but keep in mind your contributions to these tax-saving vehicles will only apply for the year in which they are paid.
- Roth IRA contributions: Although your contributions are not deductible, according to the IRS, the advantage of Roth IRAs is the potential for tax-free earnings.
- Traditional IRA contributions: Contributions are fully deductible if your employer does not offer a retirement plan, according to the IRS, and are limited based on IRS income limits if you are eligible to participate in your employer’s retirement plan. Income taxes on contributions and earnings are deferred until distributions are made.
- Health Savings Account (HSA): If you have a High Deductible Health Plan, setting up an HSA might be a good tax-saving opportunity for you. Contributions, earnings, and distributions from an HSA are tax-free as long as these are used for qualified medical expenses. It is important to note that, to qualify, you cannot be enrolled in Medicare.
Tax Myth #4: You Pay More Taxes on Bonuses
Bonuses are a great way companies reward their employees. Unfortunately, the IRS has special rules for how taxes are withheld on bonuses.
Most companies opt to take the easy route and simply withhold 22 percent of the bonus for federal income-tax purposes.
Some people think this means they’re paying more in taxes on their bonuses because their usual federal tax withholding from their paychecks is much less than 22 percent.
The key difference is that 22 percent is withheld, not actually paid in taxes. While more money is withheld from your bonus, the actual tax you owe is calculated when you file your tax return.
You then apply the money that was withheld or paid in estimated tax payments to calculate whether you receive a refund or owe money at tax time.
If more money was withheld than you owed, you’ll get a refund. Some individuals may end up getting back part of the money withheld from a bonus in the form of a tax refund at tax time, assuming enough money was withheld throughout the year to cover tax liability for other income.
The Bottom Line
Though filing taxes can be a complicated process, being aware of some misconceptions will help you avoid some of the more difficult parts of the tax season. Hopefully this helped debunk some of the biggest tax myths.
Armed with this new information, you can feel confident knowing that your tax preparations just got a little bit easier. To help those around you, you can spread awareness and understanding of how taxes work, so that neither you or your loved ones will have to worry about filing an amended return when the tax season is over.
Additional background information for this article was provided by Bret Scholl, CPA, of Scholl & Company.
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