6 common tax misunderstandings explained

A big reason why income taxes are a challenge for many people in the US is that they're pretty complicated.
Written by Trent Hamm, Contributing Writer

Income taxes are one of the cornerstones of modern life. We all have to deal with them, we sometimes stumble on them, but they're a fixed part of the path we're all walking in our financial journey. 

A big reason why income taxes are a challenge for many people is that, in the US, they're pretty complicated. Most people wind up trusting tax preparation software or handing things over to a tax preparer. It's this complexity that leads to many misunderstandings, and sometimes those misunderstandings can lead to some pretty serious financial and legal consequences.

Here are six common misunderstandings about the American income tax system, along with how you can avoid falling prey to the confusion.

"Income taxes are illegal."

This is a misunderstanding and is not true. 

Income taxes are perfectly legal and even a part of our Constitution. There are many theories out there that try to dispel this, but they mostly boil down to a misunderstanding.

The basic legality of taxes of all kinds is spelled out clearly in the Constitution. From Article 1, Section 8 of the Constitution: "The Congress shall have power to lay and collect taxes, duties, imposts and excises, to pay the debts and provide for the common defense and general welfare of the United States; but all duties, imposts and excises shall be uniform throughout the United States.

Then, Amendment 16 of the Constitution clarifies this and specifically applies it to incomes: "The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration."

Those are the foundational laws of America. You can certainly dislike those laws, and you can even work to overturn them by trying to get another amendment passed that overturns the 16th Amendment, but those are the foundational laws of the United States. IRS codes simply give the specifics of how the 16th Amendment works.

Don't fall into this trap. If someone is offering you theories on why income tax is illegal or why you don't have to pay it, ignore them. They're sharing their confusion with you or trying to mislead you for some reason. The concept of income tax is literally written into the Constitution.

"Being in the 25% tax bracket means you pay 25% of your entire income to taxes."

This isn't true. 

Whenever income brackets are shown on the news or in magazines, people inevitably seem to misunderstand what they mean. This is a common tax misunderstanding.

2021 income tax brackets

BracketTaxpayers Filing SingleMarried taxpayers Filing JointlyExample
10%Up to $9,950Up to $19,900A single file taxpayer will only pay 10% of their income up to $9,950.
12%$9,951–$40,525$19,901–$81,050A couple filing jointly will pay 12% tax on the income they earned between $19,901 and $81,050, but 10% on the first $19,900.
22%$40,526–$86,375$81,051–$172,750A single file taxpayer will pay 22% tax per $1 earned, starting at $40,526.
24%$86,376–$164,925$172,751–$329,850A couple filing jointly will pay 24% tax on the dollars earned between $172,751 and $329,850.
32%$164,926–$209,425$329,851–$418,850A person filing single will pay 32% taxes on the income they earn over $164,925, but under $209,425.
35%Over $209,426Over $418,851Taxpayers in this bracket will pay 35% on all income earned over $209,426 or $418,851 depending on their filing status.

*Source: Internal Revenue Service

When your income tax is calculated, what actually happens is that your income is taxed by percentages in different chunks. One piece, up to a certain size, is charged a 10% income tax. Another piece, up to a certain size, is charged a 12% income tax. This keeps going, slowly moving up to higher tax rates, until all of your income is covered. 

So, someone in the 37% tax bracket will take applicable deductions that lower their taxable income, then they pay only 10% on one piece of their income, then 12% on another piece, then 22% on another piece, and so on, until they're only paying 37% on the last piece. If you add up what they're paying overall, it's often way below 20%.

The truth is that the actual tax rate that people pay is virtually always lower than the tax bracket they're currently in. Don't have false illusions about the reality of income tax brackets, and remember that even if you're in a high percentage tax bracket, you're also in all the low percentage ones, too.

"Deductions will help reduce what you owe."

Unfortunately, this isn't true in most cases. 

A lot of tax advice focuses on maximizing deductions. For a segment of people, this is really useful: if you already have many deductions, every additional deduction you get reduces the amount of tax you pay in your top income tax bracket.

The problem is that a large majority of people simply can't take advantage of it.

To make tax filing a little simpler for most people, the IRS offers a standard deduction for anyone who wants it. Rather than figuring out what specific things you can deduct on your taxes by keeping track of receipts, charitable giving, and other things, you simply agree to take the standard deduction and don't worry about it. It's great for efficiency, but in that situation, there is no tax benefit for things you might do that generate deductions

Only 30% of Americans actually manually deduct items from their taxes; the other 70% just take the standard deduction, according to the Tax Policy Institute. For them, all of that info about deductions isn't useful.

Even for those who do deduct, it only saves them money if their deductions add up to more than their standard deduction. Traditionally, this only happens with very wealthy people and with people who have a large home mortgage.

"I don't need to report all of my income."

This is definitely not true. 

Many people believe that if they receive cash payment for a service or a good, they don't need to report it on their income taxes. Let's be clear: doing so is tax evasion. 

Now, in practice, if someone pays you $20 cash to mow their lawn, it's going to be tough for the IRS to catch it. However, if the person who paid you documents it and uses it as part of their tax filings and the expense can be traced back to you, that's when you're in a difficult situation.

(Note that selling your own used goods for less than you originally paid for them is not a taxable event, so you don't need to sweat cleaning out your closet unless you're making a big profit.)

The best approach is if you earn income or sell something more than you paid for it, you're better off keeping track of it and reporting it on your taxes. For most people, this amount is trivial, but it can add up to significant amounts. 

"Tax audits are scary and could happen to any American."

This is also not true, to an extent. 

The word "audit" may bring fear into the hearts of many taxpayers, but it's really not as scary as it might seem. 

For starters, CNBC reports that less than 0.5% of Americans are audited each year, and the majority of audits happen only to people earning more than $500,000 per year, according to Mackay, Caswell & Callahan. Audits are truly a rare event for the average American household.

Even when you are audited, many audits find nothing to change on your taxes, and even among those that do, it's only a relatively small portion of your income. You don't need to fear an audit unless you're doing something you shouldn't be.

Keep it simple and avoid sketchy strategies that help you dodge an audit. File your taxes correctly and honestly and audits aren't anything to worry about. 

"Large refunds are a good thing."

It depends but is mostly not true.

Many people celebrate when they get their tax refund check. It feels like a windfall in their life, a chance to fix financial mistakes or perhaps celebrate a little.

The truth, however, is that your income tax refund check is merely a sign that you overpaid your taxes throughout the year. Your paychecks were smaller than they needed to be. In effect, your income tax refund is just money that you loaned to the government for a while, and now it's giving it back to you.

What you should actually aim for is no refund at all or a tiny one. If you relish the idea of having a big windfall in the spring, just put a small amount aside in a savings account each week — say, $20 a week, transferred automatically — and then pull that money out in April to do with what you'd like. Not only is it in your hands whenever you want it, but it'll also earn a little more interest along the way.

How can you change things to get a lower tax refund? A big refund check is usually a sign that something needs to be adjusted on your payroll at work. Check with your HR department and make sure that the number of dependents is correct on your Form W-4. To be extra thorough, make sure to check out the most recent tax inflation adjustments for the tax year 2021.

[This article was originally published on The Simple Dollar in November, 2020. It was updated in November, 2021.]

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