fbpx Tax Deductions/Tax Credits: How They Work - Simple Profit

Determining what one owes in federal tax can seem mysterious. Total tax, standard deductions, itemizing, tax credits and deductions… what does it all mean? This blog will explain deductions and credits, including the new rules for the 2021 child tax credit.

Before we dig into tax deductions and credits it’s important to note there are two tax systems in the federal tax structure: 1) income tax and 2) social security and medicare tax. Individual states that collect state income tax also have their own rules for state tax.

  1. Federal income tax is a progressive tax, meaning the more you earn the more you will be taxed. Federal income tax rates range from 10% to 37%. Many mistakenly believe that it’s bad to get thrown into the next tax bracket so better to not earn more money if you are close to the next tax bracket. Thankfully, the money earned first taxed at 10% will stay taxed at 10%, and only the new income will be taxed at the next highest rate. So do not worry about going into the next tax bracket.
  2. Social security and medicare tax are typically 15.3%. Social security tax is 12.4%, but it only applies to income up to $142,800 (for 2021). After that social security tax stops. Medicare tax is 1.45%, and for those earning over $200,000 (for 2021) there is an additional Medicare tax of 0.9%. 

When someone is employed we refer to these two taxes as payroll tax. The employer pays half and gets to deduct that as a business deduction and the employee has the other half taken out of their paycheck.

For self-employed business owners, we refer to these two taxes as self-employment tax. The owner pays the full amount, but is allowed a deduction for 1/2 of the tax to make them similarly situated to an employer who…

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