Transcription
Welcome to Taxes 101. Class is now in session. No, but in all seriousness, on this channel, we make a lot of advanced tax and business videos, and sometimes the information can be too complex for people who are just getting started. So today, I want to reel us back in and set up a foundation that gives all of our new subscribers the tax basics for beginners. And look, if you watch this entire video, then by the end of it, you should understand more about how the tax system works and how taxes are calculated. So we'll be looking at taxable income, tax deductions, and tax credits. We'll also talk about why taxes work differently for businesses and investors than they do for everyday W-2 workers. We'll review how to file a tax return, and lastly, how to put together a tax plan that works for you. And I'm excited to get started. So if all this sounds good to you, then my one request is for you to hit the like button for the YouTube algorithm so this video reaches more American taxpayers who need to learn about how taxes work. Stay tuned.
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Hey there, and if you're new, welcome to our channel. I'm Sean with Life Accounting, the accounting company that helps you save on taxes and build more wealth. Now, before I dive in, I want you to know that I'm going to put timestamps for this video down in the description below so that you can skip to the parts that you want to learn the most about. Although, if you are a beginner, then I would recommend that you watch this entire video because each point builds off the next point. And if you are already familiar with how the tax system works, then you may find this video gives you a great refresher or just more reassurance. So with that, let's go ahead and get started with number one: What are taxes and why do we need them?
So in the United States, we have public services such as public education, postal services, law enforcement, healthcare, and we invest in innovation and technology. Now, the people and organizations that execute these public services, of course, need to be paid. And so we, as Americans, pay for these services indirectly through taxes. And because these public services are offered on the state and federal level, we, of course, then pay state and federal taxes. Okay, an example of a state service may be something like fire stations in your state. An example of a federal service may be the federal military. Now, of course, our tax dollars also go to other international and military affairs as well. And so you may be thinking, well, why do we care about the rest of the world? We should just focus on our country. Well, here's the thing, okay? We benefit greatly from global commerce, supply chains, different routes, alliances, and strategic partnerships all around the world, which I believe makes us one of the great nations. And when you are a business owner or investor, then you help contribute greatly to this commerce, which is a win-win for you and the government. But we'll talk about that a little bit more in just a few.
Next, let's talk about number two: How the tax system works. So theoretically, the tax code and system are very simple. Okay, it is set up in a way that makes everyone pay their fair share of taxes. So on the money you make and take home, there is a certain percentage that you must pay in taxes. But having a simple tax rate that applies to everyone isn't fair because, for example, if someone takes home $200,000 and then they have to pay a 30% tax rate, then they'd be left over with $140,000, which is enough to have a great lifestyle. On the other hand, if someone earns $40,000 and then they have to pay 30% in taxes, then they only have $28,000 left over, which is barely enough to make ends meet. So instead of having a flat tax rate in the United States that applies to everyone, we have what is called a progressive tax system where you pay higher tax rates as your income increases. And this is what helps makes the system a little bit more fair because it gives people with lower income a tax advantage to make a come-up.
Now, these tax rates are reflected as tax brackets. And I'll go ahead and put up on the screen right now the tax brackets for 2022. Here you can see as a single taxpayer, you will pay a 10% tax rate on your first $2,750 of taxable income, then 12% on your next $10,276 to $41,775 of taxable income, then 22% on the next $41,776 to $89,075 of income, and so on. And remember, you are taxed progressively. So, for example, if you make $100,000, even though that puts you in the 24% tax bracket, you wouldn't pay a flat 24% tax rate. Instead, you would only be taxed 24% on the income you made between $89,076 and $100,000, which in this case means only $10,924 would be taxed at the 24% tax rate, and the rest will be taxed at the other tax rates. Okay, so hopefully I didn't lose you with all the math, but just to reel things back in, what you need to know is that the US has a progressive tax system, which means that people with higher taxable incomes are subject to higher tax rates, and people with lower taxable incomes are subject to lower income tax rates. And this helps makes the tax system fair.
Okay, now that you understand that, let's move into number three: How taxes are calculated. So how much you need to pay in taxes depends on your taxable income, okay? Not your total income, but your taxable income. So your taxable income is what you have left over after any tax deductions. Now, by default, every American taxpayer is given what is known as a standard deduction. And the amount of your standard deduction depends on your filing status, whether you are filing single, filing married jointly or married separately, or filing head of the household. For example, I'll go ahead and put up on the screen right now the standard deduction amounts for 2022. So, for example, if you made $40,000 of income as a single filer, then you would have a standard deduction of $12,950, which would make your taxable income $27,050. And that is the amount that you would pay taxes on. But there are many other tax deductions that can help you reduce your taxable income outside of the standard deduction, which, by the way, I'll link a video on 15 tax strategies to reduce your W-2 taxes at the end of this video so you can watch that after you finish this one. And if you need help with tax prep or tax planning, then check out the first link down in the description below. Anyway, to simplify how you calculate your taxes, you would take your total income minus all your qualified deductions to get your taxable income. Then you will get a tentative tax owed because before you get to your final tax, you must also factor in what is called tax credits, which is why we need to talk about number four.
And note the difference between tax deductions and tax credits. So with our last example, I basically demonstrated how tax deductions are applied against your income, and thus they help you calculate your taxable income and can help reduce your taxable income. For example, using fake numbers, someone could have $100,000 in income, then have $25,000 in deductions, which calculates a $75,000 taxable income. On the other hand, tax credits are applied to your tax liability. For example, if someone had $100,000 in income, then $25,000 in deductions, that would calculate a $75,000 taxable income, and they may have a tax liability after all of that of $10,000. Well, if they had a tax credit of, let's say, $3,000, then that tax credit would be applied to their tax liability, and thus they would only need to pay $7,000 in taxes after that credit was applied. So most people tend to love tax credits more than tax deductions because they do provide a stronger benefit. But in general, I would always say you shouldn't strive to chase as many tax deductions or tax credits as you can, but instead, you should be aware of what is available and useful for your particular situation. And we talk about hundreds of different tax deductions and tax credits on this channel all the time, so please make sure you are subscribed to our channel if you haven't already so you stay in the loop of everything that we cover.
But some of these tax benefits are only reserved for certain people, which is why we need to talk about number five: Tax incentives for business owners and investors. So as I mentioned in my first point, taxes are a way to pay for government services, both internally and externally. But it seems that citizens simply paying taxes and governments providing services are not enough to build and sustain a thriving economy. For example, a thriving economy is one where there are many quality jobs available so that people can earn a living. And who provides the jobs? Entrepreneurs. Also, a thriving economy is one where people have quality and affordable places to live. And who provides housing? Real estate investors. And look, I follow a CPA named Tom Wright, and I like the way he breaks it down with this flowchart. Okay, the government wants to create more jobs and housing, so they give tax breaks to entrepreneurs and real estate investors to encourage job growth and housing. And thus, this helps build and sustain a thriving economy, which everyone benefits from, right? Like the government benefits from it, entrepreneurs, investors, and everyday hard-working Americans who need to earn a living wage. And so that's why business owners can write off stuff like vehicle expenses, or travel expenses, and meals and entertainment expenses, or uniform and clothing expenses, and take depreciation on their assets, and get job tax credits, and so, so much more. And that's why I am such an advocate for entrepreneurship, and I make videos on how people can grow their business as well. But it is very important to note that you shouldn't start a business just for the tax benefits because paying taxes is less expensive than operating a failing business. And if you try to game the tax system, you're going to end up playing yourself, and you could end up in prison. So if you start a business, it's really important that you do it because, okay, you really want to, like, you believe in an idea that's going to help people and provide value to others.
Now, in addition to the various tax deductions and tax credits that entrepreneurs and investors receive, they also get to leverage number six: Different types of income. So for tax purposes, there are two types of income. Okay, you have earned income, and then you have unearned income. So earned income is money that you receive from actively working. Okay, examples of earned income would be wages, salaries, tips, net income from self-employment, and so on. Whereas unearned income is money that you receive from not actively working. So examples of this would be stuff like, okay, interest income, or stock dividends, or any other types of dividends, real estate income, pension income, distributions from retirement accounts, or Social Security benefits. Now, in general, you pay more taxes on earned income, especially W-2 income, because they are subject to payroll taxes, which includes Medicare and Social Security payments. But usually, your employer will cover half. However, if you are self-employed, then you must cover all your payroll taxes, which is also called self-employment taxes. That's why unearned income is typically the best type of income for tax purposes because you are not subject to payroll taxes, and sometimes not even income taxes because on certain types of unearned income, such as the sale of assets and qualified dividends, those are taxed at a special capital gains tax rate. Whoa, whoa, whoa, Sean, so you're telling me if I don't work and I only make passive income, then I also pay less in taxes? Yup, that's exactly right. Now, of course, it takes a lot of active work and earned income to get to a place in your life where you're able to make investments that turn into unearned income. But if you want to achieve financial freedom, then the ultimate goal is to go from employee to investor as quickly as possible. And this is what is considered to be the American dream.
All right, let's go ahead and move on to number seven and quickly talk about how to file taxes. So if you are employed by someone else as an individual, then you should receive tax forms from your employer to report your income. This will come, by the way, by way of W-2s and 1099 forms. In addition, if you made any investments, you should receive tax forms reporting both your income or your tax deductions as well. Now, once you have all your tax forms, then you simply need to answer some questions on your tax return, which may reveal some other tax deductions or tax credits you may qualify for. And after you input all your information correctly, might I add, then by the end of it, like we talked about in number three, you should know your total tax paid and whether or not you currently owe more taxes or you are owed a tax refund. Now, if you own a business, like an LLC, then you may also need to complete some additional schedules or file a completely separate tax return. Now, I have videos that break down how to file your taxes as an individual and as an LLC owner, so I'll link that in the description below so that you can reference that after you finish this video.
Alright, now some people aren't happy with their tax refund or their tax liability after they file their tax return. And if that's you, then I need to talk to you about number eight: How to build a tax plan. So effective tax planning is where you are proactively trying to determine how to optimize your taxes to give you your desired outcome, which could be something as simple as reducing your overall tax liability, or aggressively reinvesting into your business, or planning and saving for retirement, or just building more streams of passive income. And so what you can do is shift your taxable income into meeting one of those goals. And here are the steps that I like to follow. Okay, step number one: Understand your tax bracket. And this is a big one because, okay, look, if you are not making a lot of money or you are not paying a lot in taxes, then you probably don't need a tax plan. But if you are, then it is important that you understand where you are and how shifting tax brackets can help save you in taxes. Okay, step number two: Understand tax deductions and tax credits. And this one is simply knowledge-based. Okay, knowing what tax incentives are available to you and which one will help you meet your overall goals. Step number three: Understand your total tax because you can reach a point of diminishing returns where you've already wiped out all your tax liability, and now you're in a situation where you may be doing more than what you need to do. Step number four: Choose your tax strategy or tax strategies. Now, there are many things you can do to optimize your tax situation, such as maximize deductions, do some legal entity optimization, retirement planning, insurance strategies, legal loopholes, niche-specific strategies, such as investing in real estate or oil and gas, and other advanced tax planning strategies. But look, you don't need to do all of these strategies, especially if you don't have much taxable income yet. Sometimes all you really need is one solid approach. I know people who can wipe out all their tax liability simply by investing into rental properties. And lastly, step number five, which is the most important step: You must implement your plan. So after you have selected your tax strategies that best meet your goals, then you must put your plan into action. Because as they say, a goal without a plan is just a dream, right? So this means you may need to set up different accounts, right? Like maybe you need to set up retirement accounts or health savings accounts. You may also need to start making the investments, such as investing in real estate or investing in oil and gas, or even budgeting business expenses for the year, and so on.
Okay, so hopefully all of this gives you a great summary of how to build a tax plan, and I clearly broke down taxes for beginners. Now, I have a little secret because look, if you made it this far in the video and you understood everything, then congratulations, you are no longer a beginner to taxes, and you may be well on your way to becoming advanced. Because coming up next, I have two more videos that I referenced in this video that may help you enhance your knowledge even more. So if you haven't checked those out already, please make sure you do, and I'll see you over there.