Financial Literacy & Independence for Teens - Step 8 - Taxation – How Does it Work?
KEY POINTS
Your paystub provides a valuable starting point for comprehending taxation since it itemizes all the distinct deductions from the total employment income.
It is crucial to carefully monitor and report non-employment income, such as capital gains, dividends, and interest, to the appropriate tax authority.
Tax deductions and tax credits are essential instruments for reducing your tax burden.
Where to Start?
Financial literacy requires an understanding of why governments impose various types of taxation as well as the three primary tax systems utilized by governments throughout the world.
Let’s begin.
Your weekly paystub serves as a starting point for discussing personal taxation. After putting in considerable effort to earn your income, it can be disheartening to witness up to 50% or even more of it being withheld and sent to the government as taxes.
Let's examine your paystub, additional income sources, tax return basics, and popular methods to minimize your tax burden.
Paystub Deductions
It can be puzzling to navigate and comprehend your paystub. Let's go over the typical source deductions that are subject to change and might differ depending on your jurisdiction.
Federal Income Tax
Employees will complete and submit a tax form (U.S. W-4, Canada TD1, United Kingdom P46) to their employer that will be utilized to determine the amount of income tax to be deducted from the employee’s pay.
Tip
You may be able to reduce the amount of taxes withheld by your employer if you make contributions to a tax deferred investment account. In the U.S. submit an updated W-4 to your employer. In Canada, file form T1213 with the Canada Revenue Agency.
State / Provincial Income Tax
Some states and provinces impose taxes that are independent from the federal taxes noted above. Such may be combined with the federal taxes withheld and shown as a single deduction on your paystub, or it may separately disclosed. The disclosure will vary by jurisdiction.
Government Pension Deduction
These deductions vary by jurisdiction. They fund Social Security in the United States, the Canadian Pension Plan in Canada, and the State Pension in the United Kingdom.
Medical Related Programs
There may be a separate deduction related to funding federal or provincial medical programs. Alternatively, the deduction may form part of the federal or provincial income tax deductions noted above and not be separately disclosed.
Employment / Unemployment Insurance
These programs may have different naming conventions, but they are typically designed to provide similar financial assistance during periods of unemployment.
Other Deductions
Additional deductions may include health insurance premiums, pension contributions, flexible spending account, charitable donations, and more.
Additional Income Sources
Employment income is typically taxed at source and reported to the employee via a paystub as described above. Other forms of income are not taxed at source and require meticulous tracking and reporting to the tax authorities. Such may include,
Capital Gains
Capital gains are generated by the sale of capital assets including stocks, bonds, real estate, and commodities. A capital gain is the amount by which the sale proceeds exceed the taxable cost basis. A capital loss is the amount by which the taxable cost basis exceeds the sale proceeds.
The tax treatment of capital gains can vary considerably across jurisdictions.
For example, in Canada, capital gains related to most capital assets are included in taxable income at a rate of 50%; however, capital gains related to an individual’s principal residence are tax-exempt.
Whereas in the United States, capital gains are taxed at varying rates based on the length of period the asset was held, and capital gains on a principal residence are eligible for a $250,000 exemption ($500,000 for married couples filing jointly).
Dividends
Companies, at their discretion, may declare dividends and distribute such to their shareholders on a proportionate basis. Dividends can be paid at regular intervals (e.g., annual, quarterly) or paid as a one-time event.
The tax treatment of dividends can vary considerably across jurisdictions and be impacted by the type of dividend declared, recipient’s residency status, specific tax laws, and more.
Dividend income may be taxed at a lower rate than other forms of income (e.g., employment income, interest) as it provides governments with a mechanism to encourage investment.
Interest Income
Interest income is an important form of passive income that can be generated from savings accounts, bonds, certificates on deposit, and loans.
The tax treatment of interest can vary considerably across jurisdictions.
Interest income derived from specific sources may be taxed at a lower rate. Governments may provide lower rates to encourage investments in areas like education or other special interest pursuits defined by the government.
Foreign Withholding Taxes
Many countries impose a withholding tax on the income sources noted above if they are paid to foreign investors. Such ensures the source country receives its share of tax revenue related to the transaction.
The amount of withholding is subject to several factors. A key determinant is the existence, or lack thereof, of a tax treaty between the source country and recipient country. Such treaties are typically designed to eliminate double taxation and specifically reference the types of income noted above.
Insurance Proceeds
Insurance proceeds are paid to the named beneficiary on an insurance policy when an insurance company makes a claim payment.
Some common types of insurance for individuals include life, health, disability, property and casualty, and annuity payouts.
The taxation of insurance proceeds will be impacted by the nature of the respective insurance policy and the jurisdiction.
Gambling Proceeds
The nature of the gambling proceeds often dictates taxation, or lack thereof. Typical sources include casino gambling, online gambling, lotteries, sports betting, raffles, and gaming machines.
The taxation of gambling proceeds varies by jurisdiction. For example, the United States taxes gambling proceeds, whereas Canada and the United Kingdom do not.
Tax Return Basics
The above income sources must be tracked and reported accurately on an annual tax return.
Legal Requirement
Most countries have a legal requirement for individuals to file their tax returns annually. Failure to file can result in penalties, fines, and potential legal consequences.
Recordkeeping
The tax return is an official document that the individual signs and submits to the government. Individuals should maintain a copy of their tax return and supporting documentation for a minimum of 7 years, to facilitate compliance with any future information requests or audits initiated by the tax authority.
Interest and Penalties
Failure to pay outstanding taxes by the due date will result in interest and penalties that can be substantial. Conversely, government’s due not typically pay interest on tax refunds owing to individuals.
Tax Return Preparation
Individuals have a selection of tax software programs available to facilitate completing and filing their tax return. Refunds are often received by recipients faster if they file their tax return electronically as opposed to submitting it via conventional mail.
We recommend individuals consider obtaining professional assistance when dealing with complex tax matters.
Social Welfare Programs
Governments typically require you to file your tax return annually to determine your eligibility for existing social welfare programs. Such programs vary by country and may include the earned income / universal tax credit, child tax credit, housing benefit, and more.
Failure to file your tax return may cause an automatic forfeiture of such tax benefits.
Common Steps to Reduce Taxes
The following highlights some of the more common methods utilized to reduce personal taxation. Such are subject to change and will vary by jurisdiction.
Standard Tax Deduction
This is a fixed deduction that reduces taxable income based on the individual’s filing status (e.g., single, married).
Mortgage Interest
In some countries (e.g., United States) mortgage interest is tax deductible, often subject to limitations, and encourages home ownership.
Principle Residence Capital Gains Exemption
In some countries (e.g., Canada) capital gains resulting from the sale of an individual’s principal residence are tax-exempt. Such is designed to encourage home ownership.
Rental Property Deductions
Various expenses may be deductible including mortgage interest, property taxes, and maintenance costs. Be sure to track and maintain copies of all invoices.
Home Based Business
Like Rental Property Deductions above, many costs may be tax deductible. You will need to allocate such expenses based on the percentage of square footage utilized by the business.
Retirement Accounts
Contributions to a tax-advantaged retirement account (e.g., 401(k), IRA, RRSP) can lower an individual's taxable income and reduce their tax liability. The funds can grow tax free while they remain in the account (e.g., capital gains, dividends, interest). Such balances are eventually taxed as ordinary income when withdrawn from the account.
Capital Loss Harvesting
Capital gains can be reduced by selling existing investments that have unrealized capital losses. Be aware that jurisdictions may deny the capital loss if that specific security is then repurchased within a defined period (e.g., 30 days).
For example, the United States and Canada define such sale and repurchase activities as wash sales and superficial losses respectively. Such will result in a denial of the tax loss in the current year. The tax loss is effectively deferred as the cost base of the repurchased security is increased by the amount of the capital loss denied.
Employee Health Savings Account
Employees may be able to contribute pre-tax income into a Health Savings Account. Such contributions may be tax deductible from the employee’s income which provides a tax advantage while saving for future medical expenses.
Charitable Donations
Donations to qualified charities can be deducted (limits apply) from taxable income. Be sure to maintain copies of all applicable receipts.
Medical Expenses
Typically, medical expenses that exceed a defined percentage of your income can be deducted from your taxable income (limits apply).
Investment Interest Expense
Interest related to investment loans may be eligible for a tax deduction.
Moving Expenses
The cost of relocating may be tax deductible and subject to a minimum relocation distance.
Gambling Losses
Losses may be tax deductible but limited to the total amount won.
Tax Credits
Tax credits reduce your taxes owing as opposed to the tax deductions noted above that reduce your taxable income. Tax software should highlight potential tax credits; however, not all software programs are created equally.
Tax authorities are constantly modifying their respective tax codes; therefore, individuals need to remain vigilant and engaged in continuous education pertaining to the tax landscape.
The following tax credits are common. Take note that some jurisdictions may not offer similar tax credits to those listed and those that do offer a tax related benefit may treat some of expenses as tax deductions instead of tax credits.
Child tax credit
This credit is designed to provide financial support to raising children. The credit typically varies based on a combination of the family income, the number of children, and the children’s ages.
Dependent tax credit
This credit is designed to provide financial support to individuals that are financially supporting a disabled or elderly individual.
Childcare tax credit
This credit is designed to provide financial support to individuals that are required to incur expenses related to childcare services.
Education / learning tax credits
These credits are designed to encourage individuals to seek additional education. Such expenses may include tuition, textbooks, and more.
Student loan interest tax credit
Like education tax credits, this credit encourages higher education and relates to interest paid on student debt.
Low to moderate tax credit
This credit supports low-income individuals and families with the aim of increasing their disposable income.
Health insurance tax credit
This credit is designed to help individuals and families afford health insurance coverage (e.g., insurance premiums).
Energy tax credit
This credit encourages individuals to adopt energy-efficient practices and invest in renewable energy sources (e.g., wind, solar, electric vehicle, geothermal). It provides individuals with a tax credit in relation to specified energy related expenses that typically promote sustainability and minimize the environmental impact.
Home renovation tax credit
This tax credit is designed to assist in home renovation. Such may be subject to specific time constraints, age requirements, and a cap on the total credit available.
For example, the homeowner may need to complete the renovations within a specified period and have an elderly or disabled family member intend on moving into the renovated premise within one year of completion.
Foreign tax credit
Income generated from foreign investments (e.g., shares of a foreign company) may pay dividends that are subject to withholding tax by the foreign jurisdiction. The foreign tax provision is designed to eliminate double taxation by allowing an individual to deduct foreign taxes withheld from their domestic tax liability.
Adoption tax credit
This credit is designed to assist with the costs of adopting a child. Some of the eligible expenses may include, depending on jurisdiction, agency fees, legal fees, travel expenses, medical expenses, re-adoption expenses, and more.
BOTTOM LINE
Your paystub serves as a valuable initial step in understanding taxation as it meticulously itemizes all the various deductions from your total employment income.
Additionally, it is of utmost importance to diligently track and report non-employment income, including capital gains, dividends, and interest, to the relevant tax authority.
To further ease your tax burden, leveraging tax deductions and tax credits becomes a critical aspect of optimizing your financial situation.
By staying informed about these crucial elements of the tax system, you can make informed decisions and effectively manage your tax liability.
