*** The following post was written based on 2015 tax numbers (standard deduction, personal exemption, etc). The mechanics are still sound, though the actual numbers will now be slightly off. ***
Taxes in the U.S. are complicated. They seem like a huge black box, but here’s a brief summary that should capture most of what you need to know.
Step 1: Calculate taxable income
What you first need to understand is that all U.S. tax calculations are based on something called taxable income. Taxable income is pretty easily computed, and the equation is shown below. It’s equal to your wages minus your pre-tax contributions (such as healthcare premiums, retirement contributions, etc.) minus your standard or itemized deductions (more on this below) minus personal exemptions (simply $4,000 times the number of people at home).
— Pre-tax payroll deductions (401k, healthcare premiums, etc.)
— Standard or Itemized Deduction (See below)
— Personal Exemptions ($4,000 * number of people in home)
= Taxable Income
Standard or Itemized Deduction
In the U.S., you get to deduct a certain dollar amount from your taxable income. This occurs in one of two ways: 1.) Standard Deduction or 2.) Itemized Deduction.
1.) Standard Deduction (70% of American’s fall under this category)
If you’re married filing jointly, the standard deduction is $12,600 for married households filing jointly (half that if single) in 2016.
2.) Itemized Deduction (30% of American’s fall under this category)
If you have itemized deductions in excess of $12,600, then it makes sense to itemize. Popular items to deduce are: mortgage interest, property taxes, state income tax, charitable contributions, and healthcare expenses. But be careful of the economic interpretation here. If I pay $13,000 in mortgage interest in a given year, I may think I’m getting a good deal because it’s deductible. But remember that you were getting a $12,600 deduction for free even if you didn’t have a mortgage. So by paying $13,000/year in mortgage interest only reduces your taxable income by $400 over the standard deduction.
Let’s plug in some numbers to make this more tractable. Say I make $100k in a year, contribute $10k to a 401k and $10k in pre-tax insurance premiums. Let’s say I also take the standard deduction and am married with 5 kids at home.
Taxable income = $100k – $10k – $10k – $12.6k – $28k = $39.4k.
Let’s cross-check using Turbotax’s Taxcaster Tool (link, though they also have apps for Android & Apple).
Unfortunately the tool doesn’t have a spot for pre-tax payroll deductions like 401k’s or healthcare premiums, so we have to subtract those out manually. Our income after 401k and healthcare premiums is $100k-$10k-$10k = $80k. This is the number we put into Turbotax as “Your Income.” After we input the $80k into Turbotax, it computes the taxable income as $39.4k, just as we had predicted above. Note the $12,600 standard deduction was claimed automatically as were the $28k in personal exemptions (7 people at home * $4k per person).
To illustrate the point of standard vs itemized deduction, note what happens to the “Total Deductions” line as I modify the mortgage interest. Let’s input $13k in mortgage interest to be consistent with the example mentioned previously.
Note that the standard deduction of $12,600 is no longer used, and instead has been replaced by the itemized deduction of $13,000. Again, in this scenario, $13,000 of mortgage interest only reduces our taxable income by $400 more than the standard deduction.
For the remainder of the post, I’ll revert to the standard deduction with taxable income of $39,400 as shown above.
Step 2: Calculate Taxes Owed
In the U.S., we have a progressive tax system. What this means is that the more money you make, the higher rate each dollar is taxed.
What this looks like in practice is like this (link):
So now that I have $39,400 in taxable income, we simply have to look at the above tables to find out how much we owe in taxes.
Since we’re married filing jointly, the table says that the first $18,450 in income is taxed at 10%, resulting in $1,845 in taxes. This leaves us with $20,950 ($39,400-$18,450) to be taxed at higher brackets. Since our taxable income does not exceed the 15% bracket (which caps out at $74,900), all of the remaining $20,950 will be taxed at 15%, resulting in an additional $3,142.50 in taxes owed. Summing the two gets us to $4,987.50 ($1,845+$3,142.50).
Does this number check with Taxcaster? Yes. Taxcaster computes taxes owed as $4,991. The few dollar difference is due to the fact that the IRS technically computes taxes with a look-up table rather than by actual math as we just used. This is a relic of the past that remains operable to this day.
So are we done yet? Unfortunately not. We still need to reduce our taxes with tax credits. Here’s what Turbotax says about tax credits:
Your allowable credits, including any and all child tax credits, American Opportunity Tax and Lifetime Learning credits, Child Care Credit, and the Earned Income Tax Credit. Credits reduce your tax bill dollar for dollar.
In my case, the Child Tax Credit is calculated as $1,000 * the number of kids at home, which is 5, resulting in a $5,000 Child Tax Credit. This credit begins to phase out at $110,000 in taxable income at a rate of 5% (if I had $111,000 in taxable income, then my Child Tax Credit would be reduced by $50 to $4,950). This credit is refundable, meaning that it if it is greater than the taxes owed I will receive a refund. My tax credit is $5,000, and with taxes owed of $4,987.50 I would actually receive a refund of $12.50 in this scenario on $100k in income. Note that this refund isn’t simply the returning of taxes I’ve paid into the government during the year. In Turtbotax I set the amount of taxes we’ve already paid to $0. This is a tax credit.
So in this example, I hope to have conveyed the following:
- You can actually compute your taxes. Once you understand the mechanics, you’ll see how you can benefit from the system.
- Don’t get fooled into thinking that itemizing is that much better than the standard deduction.
- The U.S. tax code is progressive. Lower levels of taxable income are taxed at low rates, and high levels of taxable income are taxed at higher rates. The first $18,450 per year in taxable income are always taxed at 10% for all people (even Warren Buffet). The next chunk is taxed at 15% and so on.
- Tax credits, particularly with kids, are complicated. The Earned Income Tax Credit and the Child Tax Credit are pretty difficult to understand. It’s beyond the scope of this blog to talk about all of the details.
- It pays to lower your taxable income. You can do so by having lots of kids (like I’ve done), but the much easier way of doing so is by maxing out employer sponsored retirement plans like 401k’s.
How I use the above knowledge to manage my tax liabilities
During your working years, the name of the game is tax deferral. In retirement, I plan to spend around $45k/year. Recall that $12,600 of this is tax free due to the standard deduction. Recall that another $8,000 is tax-free due to personal exemptions. The two combined bring my taxable income to $25k/year in retirement. $25k/year in taxable income is taxed at a very low rate (as shown by the tax tables above), so my main objective during my working years is to reduce my taxable income. Here’s how I’m doing so.
Gross income: $200k
— $9k 401a (max allowed by my employer)
— $18k 403b (max allowed by IRS)
— $18k 457 (max allowed by IRS)
— $6.75k HSA (max allowed by IRS)
— $1k healthcare premiums
— $12.6k Standard Deduction
— $28k Personal Exemptions ($4,000 * number of people in home)
= $104.65k Taxable income
My income is too high to benefit from a deductible traditional IRA, but if it were lower I’d further reduce my taxable income by $11k/year ($5.5k/person/year).
Now that we understand the tax code a little bit, here’s a tool that I put together which should be helpful for tax planning purposes: http://www.frugalprofessor.com/updated-tax-calculator/
Links to other steps in series:
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