How Taxes Actually Work | An Accountant Explains!

Let’s talk about how taxes actually work. Where’s all your money gone? Don taxes. This is one of the most fundamental concepts in personal finance. Taxes are something that affects every American, and yet most Americans—they remain a complete mystery. Over half of all Americans said they had no idea how taxes even work. Knowing what your money’s doing and where it’s going is crucial to your wealth-building journey.

I b my money. You know what else is a crucial component to your wealth-building journey? Subscribing to the Money Guy Show. So make sure you hit that subscribe button and even ring the notification bell.

Okay, let’s jump right—

Marginal Tax Rate

The most common misunderstanding about how taxes work is usually around your marginal tax rate, also known as your tax bracket. Let’s say you’re a single person making $100,000. That means your marginal tax rate is 22%. Now you might be thinking that means you pay $22,000 of taxes or 22% of $100,000—but that’s not how it works. A marginal rate is actually the rate you pay on each additional dollar.

Take a look at the federal income tax brackets. What this means is that you pay 10% on the first $11,600 of your pay. Every additional dollar up to $47,150 is taxed at 12%, and only the dollars from $47,150 all the way up to $100,000 are taxed at that 22% tax rate. If you do the math, you’re actually paying $17,500 in taxes. That means that your effective tax rate is just over 17.7%.

So when you hear people say, “I don’t want to make any more money ’cause that’ll put me into a higher tax bracket and I’ll actually make less,” that is completely wrong. You hate money or something?

Deductions

You might hear people mention tax deductions. You might also hear them talk about tax credits. Your head starts spinning. Don’t worry—we’re going to help you figure this out. The Money Guy’s here to help you navigate and know what all these tax terms mean.

So let’s clear this up: A tax deduction is a reduction in your taxable income. This means if you have a $1,000 tax deduction on your $100,000 income, your taxable income would only be $99,000 after the deduction. One thing to note about deductions is they come really in two forms: There’s the standard deduction, which is based upon your filing status—single, married—and then there’s itemized deductions.

The standard is something the government just gives you. Overall, itemized means you have to exceed the standard, and now you get to actually take every one of those deductions above and beyond that standard deduction mark. There are deductions you get to take even if you’re claiming the standard deduction. I’m talking about Health Savings Account contributions. I’m talking about IRA contributions.

However, I want to make sure I don’t skip out on those itemized deductions. When we talk about itemized deductions, we’re primarily talking about charitable contributions, we’re talking about your state and local taxes that you pay, as well as that mortgage interest that you’re paying on your outstanding loan.

Tax Credits

Now the next term—a tax credit—is actually more powerful than a deduction. It is a reduction in the amount of taxes owed. So if your tax bill on $100,000 income is $17,500, a $1,000 tax credit means you would actually owe $16,500 in taxes.

A common example of this is the Child Tax Credit, where parents or guardians can claim a tax credit for their child if they’re under 17, have a Social Security number, and are claimed as a dependent on the taxpayer’s return.

It is very important to remember all of this should be done honestly and legally. Tax avoidance is legal. Tax evasion—not. If you want a more comprehensive guide on the ins and outs of taxes, I want to encourage you to go to money.com/resources. We update our tax guide every year to keep you on the right track. Make sure you check out that resource and all the other free resources at money.com.

And also make sure you like and subscribe to the content so you can own your financial future that much sooner.