Day 11: Understand Taxes
I rarely write about taxes, but that’s not because I don’t think about them, worry about them, and pay them. The truth is, until very recently, I never really understood all that much about taxes. Every April, I would file my federal income taxes, ‘get back’ about $1000, and go on about my life. Now that I’m saving money, investing for retirement, and funding education savings accounts, I’ve begun to learn a bit more about taxes and how they affect financial decision making.
I’m amazed by how many kinds of taxes we pay. Let’s see – property taxes, social security taxes, automobile taxes, sales taxes, state / federal / local income taxes – the list goes on and on and on. Trying to figure out how to minimize the impact of taxes can be difficult. But, just because it’s difficult, that doesn’t mean you shouldn’t try.
Here is my list of things that I’ve learned about taxes in the past few years:
Money invested in 401(k)s and 403(b)s grows income tax deferred. This means that you will pay tax when you withdraw the money from your account, but you will not pay tax in the year that you earn the money. So, if I contribute $10,000 to my 403(b) in 2007, I will not have to pay taxes on that money in 2007. But, I will pay tax when I withdraw that money from my account when I retire, at whatever my income tax rate is at that time.
Money invested in a Roth IRA grows tax free. This means that you will not pay tax when you withdraw the money from your account, but you will pay tax in the year that you earn the money. So, if I contribute $2000 to my Roth IRA in 2007, I will have to pay taxes on that money in 2007. But, I will not have to pay taxes when I withdraw that money from my account when I retire.
Several states have tax-free holidays. During these holidays, you can buy clothing, school supplies, and electronics without having to pay state sales tax. (Checkout this list of state sales tax holidays. It’s a little late to take advantage of these in 2007, but you can get ready for 2008.)
If you are getting back a substantial federal or state income tax refund, consider changing your withholding. That way, your paycheck will be a little higher and you can stop loaning Uncle Sam money at zero percent. Take that extra amount in each paycheck and use it to get out of debt.
I present all of the above as MY understanding about how taxes “work”. That being said, I strongly urge YOU to find out about how taxes affect YOUR finances. I do not give professional financial advice. Get in touch with a tax professional and let her guide you through the process of understanding taxes. You might find that you are paying hundreds (or thousands) in unnecessary taxes.
Have you learned something new about taxes? Leave a comment and let us know. If you are a blogger, write a post about taxes and their impact and contact me. Iâ€™ll be more than happy to link to your post.