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10 Things You Should Teach Your Kids About Taxes

Updated for Tax Year 2012


OVERVIEW

The tax system isn't typically taught in school, so kids are generally unaware of tax issues until they're teenagers working for the first time. Learning about taxes can teach children the valuable skills of budgeting, saving and managing their finances.


Taxes seem to be an adult issue, something kids rarely have to worry about. The tax system isn't typically taught in school, so kids are generally unaware of tax issues until they're teenagers working for the first time. Preschoolers might be a little young, but most elementary school kids are ready for basic tax lessons. Learning about taxes can teach children the valuable skills of budgeting, saving and managing their finances.

Why Americans pay taxes

Knowing what tax money pays for can help kids understand why they must pay taxes.

As tax consultant and former Internal Revenue Service agent Burton E. Smith explains, "Taxes fund a wide range of government programs, including education, health care, defense and transportation."

Kids should develop an understanding of how the tax system benefits everyone, which can lessen the resentment they'll feel when they see a big chunk of taxes taken out of their first paycheck.

Different kinds of taxes

Federal income tax isn't the only tax kids need to understand; they should also learn about sales tax, state income tax, capital gains tax and payroll taxes. Not all states impose sales or income taxes, points out Smith, but even kids in those states should learn the concepts. Property, estate and gift taxes might be abstract ideas for kids, but will become more important as they grow up and have families of their own.

The U.S. income tax model

The federal income tax is overall a progressive model, where the tax rate generally increases as income increases. Certain areas of taxation follow different models: Social Security and Medicare, for example, are regressive taxes, with lower-income earners paying a larger share of their wages than higher-income earners.

Some states have proportional income taxes, meaning the tax rate is the same for everyone regardless of income. Details about the different tax models aren't necessary for most kids, but they should grasp the basic concept that federal tax rates increase as income increases.

Paycheck withholding

In the United States, income is taxable when it is earned, even though tax returns are filed on an annual basis. For most taxpayers, this is accomplished through payroll withholding. Smith suggests using an allowance to help illustrate the concept: Keep 10 percent of the allowance as "withholding," and set aside the money to help pay for a special event or family trip.

Why large refunds aren't a good thing

Receiving a large tax refund may seem like a windfall, but kids should learn that they're really cheating themselves when they have too much tax withheld. "The ideal situation is to owe no tax and have no refund," explains Smith. If you get a large refund, you're essentially providing the government with an interest-free loan. Instead, explain to kids that they can reduce their withholding and put the difference into an interest-bearing savings account.

Filing income tax returns

Most kids won't actually need to file an income tax return until they have their first job. You can help your kids prepare a mock tax return, using their allowance "income" and "withholding" information. The IRS website contains blank tax return forms and instructions to help with this exercise.

Information reporting to the IRS

"The requirement to pay taxes often causes people to try to find ways to avoid them," comments Smith. Kids should learn to resist the temptation of illegal tax evasion, however. Employers, banks and investment companies report to the IRS the amounts they've paid you. These information returns are compared to your income tax return for accuracy; if you fail to accurately report your income on your tax return, you may face additional tax, penalties and interest.

Social Security and retirement savings

Part of the federal government's function is to provide for the general welfare of the country. This includes Social Security, which provides income to retired workers. Social Security income alone is not always adequate, and the future of the program is not guaranteed. As a result, notes Smith, the IRS encourages people to save for their own retirement by deferring taxes on retirement accounts. Incorporate a "401(k)" into your child's allowance by setting aside a small percentage; if you're withholding "taxes" from the allowance, be sure to subtract the 401(k) amount before calculating the withheld amount.

Exemptions, deductions and tax credits

Once your kids are thoroughly depressed about the effect of taxes on their future income, let them in on the fact that gross income is not the same as taxable income. Explain exemptions and deductions, which decrease their taxable income, and tax credits that may reduce their tax further. This also provides a good opportunity to encourage giving to others; kids can make charitable contributions from their allowance and deduct that amount from their gross income on their mock tax return.

Recordkeeping requirements

Teaching kids to keep accurate records will benefit them greatly if they're subject to an IRS examination in the future. "Even if you're right about your numbers," explains Smith, "without proof the IRS may not accept your information." Kids should understand that if they owe additional tax after an examination, they will likely also owe penalties and interest. Good recordkeeping skills can benefit kids in other areas of life, as well.

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The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.


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