In the majority of jurisdictions, income that is earned is subject to income tax at a certain rate, meaning that governments have a claim on all of the income that you earn. Certain types of income may be excluded from taxation at the discretion of the government, for example you may not have to pay tax on certain forms of disability income.
As a rule though, all reported income will be subject to being included for the purposes of taxation, provided that it is reported. People do earn income that does not become reported, although there are penalties involved, including criminal ones, that may be applied if one is found to be evading taxation.
With employment income, a certain percentage is deducted at the source, where employers will remit to the government a certain percentage of the income paid to their employees, where the goal is to approximate what the tax obligation on this income will end up being.
Potential deductions are often calculated into these amounts as well, and ideally, taxpayers will end up owing as close to the amount that was deducted as possible, to reduce the risk of having them owe significant amounts at tax time and having difficulty paying it.
Governments of course prefer to collect tax money up front when possible. With employers being ordered to act as their agents and collect tax from them on an ongoing basis, by withholding these amounts from their employees, this often does a favor for those taxed, those who may not be that well suited to save up the money they will owe in income tax and pay the yearly sum promptly and without any hardship or worry.
Considering how poorly many people manage their own finances, tax withholding can often be a good idea for both them and the government, because otherwise it may be too tempting to spend the money one needs to save up to pay their taxes, especially with a tendency to spend more than they earn.
Income Tax on Self Employed Earnings
Not everyone falls into a strict employment arrangement, and those who are self employed to some degree, whether that mean that they are in business for themselves or employed as an independent contractor, will need to manage their tax obligations themselves.
In these cases, taxpayers will generally not be permitted to pay their taxes in an annual lump sum, but will instead be held to more periodic tax payments, generally quarterly. Self employed individuals are therefore given more latitude here, but at the same time, have to be more diligent about preparing to pay their taxes in an orderly manner when due.
In all cases, tax filing is an annual event, where we go from looking to approximate one’s income tax obligations to actually figuring it out, to the penny, by way of a tax assessment. This includes compiling one’s taxable income, applying allowable deductions from it, calculating the amount of tax owed, and comparing this to the amount of tax that was paid during the year.
The net of this will be reflected in either a refund or an obligation, which will be paid or is due shortly after the filing. Should one fall behind with their taxes, these amounts will be subject to interest and other financial penalties, and ultimately the government may seek to collect past due amounts actively.
Income Tax and Net Income
Self employed individuals generally have a wider latitude as far as the number and amount of deductions that they can make, compared with individuals. This makes sense because self employment income usually involves business expenses which are not considered income. If your self employment earnings are $100,000 but you spend $50,000 in business expenses to earn this, your income would be the $50,000, not the $100,000.
Individuals also have expenses related to their employment, for instance transportation costs to and from work, but this is not generally viewed as a valid deduction, and these costs do tend to be more trivial as a percentage of overall earnings. Perhaps we could argue that these should be included anyway, as a matter of principle, but governments do want to keep things simple, and therefore generally do not permit such expenses to be deducted.
Depending on the jurisdiction, there may be a number of other things that you can deduct from your income to reduce the amount of tax you need to pay. Everyone has a certain amount of deductions available to them, and it does pay to be fully aware of what you may be able to deduct when you do your taxes.
This is why many people hire a tax professional to do their taxes, although in some countries, what you may be able to deduct is fairly limited and for a great many people quite straightforward, and tax preparation software may be all that one may need to be able to file with accuracy.
In some countries though, particularly in the United States, the tax code may be complex enough that taxpayers, particularly those with more complex tax situations, may require professional advice.
With self employed earners, or those who generate a significant portion of their earnings from self employment income, including investors, having your tax return prepared by a professional is very often a good idea. It will cost you a little more but if you can take advantage of some deductions that you wouldn’t otherwise have been aware of, it can be well worth the extra money.
There’s also the concern that you may make mistakes on your return if you do it yourself, and having a professional do it will alleviate these fears. It’s not that professionals don’t make mistakes, but this may be far less likely when the preparer does this for a living instead of an individual filer with their more limited knowledge.
Whenever we do this, we in essence are hanging on to the tax money that is owed on a certain portion of what we make. Therefore, we not only are saving a certain amount for the future, we also get to invest the tax portion of this income, the portion that would have been given to the government had we not deferred the tax on these amounts.
The amount of tax that is deferred from these contributions in a given year will be equal to our marginal tax rate on the contribution, and therefore, the higher the tax bracket you are in, and the higher your marginal tax rate is, the more tax money you will receive by doing this.
While we generally will look forward and look to predict what our marginal tax rates will be at the time of withdrawal, when we declare this income, generally at retirement, the ability to use this tax money over the interim is also a benefit, provided we achieve a positive return on our investments generally.
This part can add up to significant amounts, especially when measured over longer time frames such as decades, combined with at least decent return on investment. The longer you have until you need the money, and the better your expected return, the more valuable hanging on to this tax money becomes.
Governments want you to save, especially for retirement, and provided that taking advantage of these tax programs is in your benefit, it is certainly wise to do so. We also are given incentives to prepare adequately for our golden years, which is something we should be doing anyway.
Other Tax Considerations
Depending on where you live, there will be a number of other tax programs and deductions that may be available to you, and it always pays to at least become aware of what these opportunities are and take advantage of them when appropriate.
When we do take advantage of programs or deductions, we must be clear on whether the benefits involved are worth it, which means adding the tax benefits to the value received. We need to make sure that we aren’t overly weighing the tax benefits here to the point where we end up spending money on things we otherwise should not, or to a degree we should not.
As an example, charitable donations are generally tax deductible, and while it’s good to donate to causes you believe in and do so within your means, you don’t really want to donate beyond your means just because it’s a “tax write off.” You have to bear the costs of the donation less your marginal tax rate, and while this does mean that your end of the donations will go further, that’s all this accomplishes.
We also need to be aware that not all the tax that we pay is income tax, and we also pay consumption tax on just about everything. We can reduce the amount of tax we pay by spending less money, which not only saves paying the tax, it also of course saves the amount that would have been spent.
There really isn’t any practical value in paying less tax here though, as we judge the value of something based upon its final price. Some goods are taxed more highly than others though and that will raise the bar at least, resulting in higher final prices and requiring more justification.
It is true that the more we earn, the more tax we tend to pay, and given that earning more income should be a goal, the fact that we may have to pay a higher percentage of marginal income to the government never should be a concern.
On the other hand, if there are ways that we can earn more income and reduce our tax burden, and we are benefited overall by doing this, then this does tend to be well worth considering.
We should tend to judge our situations not so much by how much tax we paid or even how much we earned, but how well we are managing our finances. Sound personal financial management is at the forefront here, where tax considerations are merely a part of that, and not even that big of a part when we consider the limited impact that tax management tends to have on the overall picture.
It still can have an impact though, and we are wise to be aware of the options we have here to reduce tax obligations and save money on taxes, and also be aware of the degree that doing so may help us overall.