4 Myths About How Taxes Work, Debunked
Taxes are complicated, but that’s no excuse to avoid educating yourself on some basic facts that help reduce tax-time anxiety.
Taxes are complicated. Most people end up hiring a CPA or a tax preparer or buying software to file their taxes. You answer a bunch of questions, and the preparer somehow puts the answers to those questions on a few sheets of paper, which you send to the Internal Revenue Service (IRS). Because people don’t often learn how to file the paperwork on their own, many don’t understand how taxes work.
As someone who used to prepare taxes, I’ve had people ask me some strange questions. After years of answering these questions, I’ve realized there are many misconceptions about how taxes work. Here are a few things people usually have trouble with:
- Understanding tax brackets and tax rates
- How itemized deductions work
- Whether or not to pay off loans with tax-deductible interest
- How work bonuses are taxed
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 are as follows:
Taxable Income — Tax Rate
- $0 to $15,000 — 10%
- $15,001 to $30,000 — 15%
- $30,001 to $100,000 — 25%
Using theoretical numbers, if you had taxable income of $30,000 last year, you would pay 10 percent on the first $15,000 and 15 percent on the 15,001st dollar through the 30,000th dollar. If you earned $30,001, you’d pay only 25 percent tax on that one dollar over $30,000! You wouldn’t pay 25 percent in taxes on all $30,001.
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.
While this may be true in some cases, many who itemize deductions aren’t saving nearly as much money as they think they are.
When you take itemized deductions on your tax return, you no longer get the standard deduction. If your itemized deductions don’t exceed your standard deduction by a lot, you won’t save much in taxes. All that you’re saving is the difference between your standard deduction and the total of your itemized deductions. Plus, a deduction only reduces your taxable income — not your actual tax due. So if you’re in the 25-percent tax bracket, each dollar of deduction saves you only 25 cents in taxes paid.
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. While 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, usually 25 cents or less, per dollar of interest you pay. While paying 75 cents is better than paying $1, paying nothing is the best in my book. Paying off your loan saves you 100 percent of the interest you were paying.
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 25 percent of the bonus for federal income-tax purposes.
Some people think this means they’re paying more on taxes on their bonuses because their usual federal tax withholding from their paychecks is much less than 25 percent. The key difference is that 25 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 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.
Armed with this new information, you can help spread awareness and understanding of how taxes work.