Social media is full of tax information which could be good but the vast majority of the info is coming from non professionals who have never made it through an audit. This has created so many misconceptions on taxes.
Here are 6 things most people to not understand about taxes.
This is not how taxes work in the US. Taxes are marginal, meaning not all income is taxed in one bracket.
Some gets taxed at 0%, 10%, 12%, 22%, 24%, 32%, 35%, and 37% depending on how much income you make. Let’s say you are married and make $129,200. After the standard deduction (which we will talk more about later) you would have a taxable income of $100,000.
From $0-$23,200 you would pay 10% tax = $2,320
From $23,200 to $94,300 you would pay 12% tax = $8,532
From $94,300-$100,000 you would pay 22% tax = $1,254
Total tax = $12,106
Some was taxed at 0% (from the standard deduction)
Some at 10%
Some at 12%
And some at 22%/
You fill up each bracket then move to the next. This is what marginal means. So no... you are not entirely taxed at 22%.
There are so many misconceptions around business deductions it is hard to cover each one, but I am going to take a stab at a bunch of them.
"An LLC is a tax savings vehicle"
An LLC is not a tax savings vehicle. It is simply a way to limit your liability. An LLC vs being self employed and not having one set up still gives you the same options in terms of taxes. Either way can utilize deductions which get subtracted from your revenue. The end result is your profit, which is what you get taxed on.
You save on taxes by the amount you spend
A common misconception is that a $5,000 expense in the business will save you $5,000 on taxes. This is not true unless it is a tax credit (way less common). Most spending you do is a tax deduction. This means it saves you by your marginal tax rate. If you are in the 22% tax bracket and have a $5,000 deduction you would save $5,000 x .22 = $1,100 on taxes.
“It’s a write off”
First of all write offs are not free. Like I talked about above, they are just reducing your taxable income. You are still spending money.
Also just because you buy something through the business does not mean it is even deductible. Many people are paying for things in their life through the business that are not ordinary and necessary. This means that you will not be able to write it off. It will get added back in to your profit and you will pay taxes on it.
What is withheld and what your tax liability is are 2 vastly different things. This is one of the most common misconceptions I see. People think that what gets withheld from their paycheck is their exact tax liability but this could not be further from the truth.
You fill out a W4 to try and get your withholding as close to right as possible. But it can be way off. I have sat down with clients who elected to have $0 set aside for federal or state taxes. That did not mean they did not owe taxes.
We also commonly see 22% withholding for clients on RSUs even if they are making $800k of income. This means they will under withhold by at least 15% on a large amount. Moral of the story is that what gets withheld is just a guess.
At the end of the day, you need to invest the time into filling out your W4 accurately, it’s not HR’s responsibility, nor the payroll provider. They are your taxes - therefore it’s your responsibility.
Most people think their mortgage interest, charitable giving, etc. are all a deduction. They are partially right.
These are deductions. But… they only impact your return if your itemized deductions are larger than the standard deduction. If all your deductions are lower than $29,200, then you are not actually realizing their impact. The statistic is that nearly 85% of people take the standard deduction. Remember this when you think buying a house is good for taxes.
I would say at least 50% of the business owners I sit down with think this. They assume that they are only taxed based on the dollars that are taken out of the business. But this is not true for:
- S Corps
- Partnerships
- Sole Props
- Single Member LLCs
These are all pass-through entities or disregarded entities. This means that the profits of the business flow through to you, the owner, on your tax return. So whether you leave the money in the business or you take it, you are taxed on that profit either way.
This means you should only keep money in there that has a purpose. Some examples are for operating expenses, emergencies, bonuses, retirement contributions, savings for a purchase, etc.
This is talked about all over social media and it is true. IT CAN offset your income, but only if you have REPS status and pass material participation tests. the other way is if you utilize the short term rental loop hole. But with both, you need to hit material participation tests which very few are doing. It has to be done by the book. You have to be doing the work.
These are 6 of the most common things people do not understand about taxes. If you can learn and understand these, you will be ahead of 99% of people.
Financial Advisor