US Taxes 101

This post is going to summarize how US federal taxes work at a high level. It should be helpful for those unfamiliar with the system and looking for the fundamentals to help them better understand tax reducing strategies.

Overview

At a high level, taxes are really simple. You make some money, the government takes a chunk as taxes, and the leftover is yours to keep. We file taxes to make sure the government took away the correct amount of money over a period of one year.

Withholding

When you get your paycheck, you’ll notice some of your earned money was withheld. This means the government took away a portion of money as taxes. The amount withheld is determined by what you fill out on your W-4 form. After filing your taxes and figuring out the amount of taxes you needed to pay over the year, you will end up either owing the government more taxes if the government under-withheld, or getting a tax refund if the government over-withheld.

It’s always better when the government has under-withheld, because that means you had more money to spend throughout the year. After all, there is no penalty for owing money to the government as long as you pay it before the deadline. A tax refund can indicate you didn’t properly fill out your W-4 form, allowing the government to take away more money from your paycheck than they should have.

Marginal Tax Rates

The amount of taxes you owe each year is determined from your taxable income. The tax amount is calculated using marginal rates, meaning you don’t pay the same tax rate for all of your taxable income. This is to allow higher tax rates for those with higher income. Here’s an example:

Suppose I am a Single Filer with $50,000 taxable income. Here are the 2014 tax rates:

Rate Single Filers Married Joint Filers Head of Household Filers
10% $0 to $9,075 $0 to $18,150 $0 to $12,950
15% $9,076 to $36,900 $18,151 to$73,800 $12,951 to $49,400
25% $36,901 to $89,350 $73,801 to $148,850 $49,401 to $127,550
28% $89,351 to $186,350 $148,851 to $226,850 $127,551 to $206,600
33% $186,351 to $405,100 $226,851 to $405,100 $206,601 to $405,100
35% $405,101 to 406,750 $405,101 to 457,600 $405,101 to $432,200
39.6% $406,751+ $457,601+ $432,201+

This table means for a Single Filer, the amounts $0 to $9,075 is taxed at 10%, amounts $9,076 to $36,900 are taxed at 15%, and so forth. In my case, my total taxes would be

10% * $9,075 + 15% * ($36,900 – $9075) + 25% * ($50,000 – $36,900) = $8,356.

This formula in words means I owe 10% on the amount I make between $0 to $9,075, 15% on the amount I make between $9,075 to $36,900, and 25% on the amount I make between $36,900 to $89,350. Marginal Tax rates are an important concept to understand when trying to minimize our taxes.

Minimizing Taxes

The tax system is so complicated that there are hundreds of ways to save or lose money through taxes. The main thing to focus on is lowering your taxable income. By doing so, you lower your taxes and end up having more money to spend. One thing to note is how marginal tax rates play a role in how much you save.

When you lower your taxable income, the marginal tax rate of your current taxable income determines how much money you save. Going back to our example, we were a Single Filer with $50,000 taxable income, which falls into the $36,901 to $89,350 bucket that gets taxed at 25% marginal rate. This means if I do something that lets me reduce my taxable income, the money I save will be 25% of the reduction. Note this only applies until you’ve reduced your taxable income to $36,901, at which you will fall into a tax bracket with lower marginal rate.

As an example, let’s say I decide to donate $5,000 this year. Cash donations are fully deductible, meaning they can reduce your taxable income by the amount you donated. In this case, our taxable income drops from $50,000 to $45,000. The tax we now pay is:

10% * $9,075 + 15% * ($36,900 – $9075) + 25% * ($45,000 – $36,900) = $7,106.

instead of the original $8,356. By doing the donation, we saved $8,356 – $7,106 = $1,250, which is 25% of the $5,000 we donated.

By making donations fully deductible, someone who is in the 25% marginal tax bracket is able to save 25% on the cost of the donation; in our case, spending $3,750 to buy a $5,000 donation. This is true for any cost that is fully deductible. They are essentially 25% off if your taxable income falls into the 25% marginal tax bracket.

People often like to throw around the term “fully deductible” to advocate something is worth spending on. For example, buying a house is better than renting because mortgage is “fully deductible.” At the end of the day, it just means you’re able to buy something cheaper by 10%, 15%, 25%, or whatever marginal tax bracket your current taxable income is at. Because it depends on the person’s taxable income level, saying something is “fully deductible” still requires us to do the math instead of blindly use it as a reason to spend on something.

Standard vs Itemized Deduction

A deduction is a dollar amount you can subtract from your taxable income, which reduces tax and saves you money. One of the major choices you can make that will affect your taxable income is deciding between taking standard or itemized deductions. It is required of all taxpayers to choose to apply only one of these deductions.

The standard deduction is based upon your tax filing status (single, married, etc.) and doesn’t have much room for manipulating.

The itemized deduction on the other hand has several categories that allow you to legally manipulate the number. Things like major medical/dental expenses, non-rental mortgage, charity contributions, educational expenses, and many more can be used to increase your itemized deduction and make it significantly higher than the standard deduction.

An often overlooked trick is to reduce the amount that gets withheld from your paycheck by factoring in expected itemized deductions into your W-4. Recall the W-4 form is something you must fill out to let employers know how much to withhold in taxes from your paycheck. If you know you’ll be using itemized deductions, there is a section on the W-4 that lets you estimate the deduction amount so that less money is withheld from your paycheck to compensate for the lower taxes as a result of the larger deduction.

Further Reading

Now that you’re more familiar with the tax system, the next steps would be to explore the various tax-saving strategies. Begin by thoroughly completing your taxes using a tax software, even if it’s not due.  Take the time to understand the math behind all the boxes, and figure out which boxes increase or decrease your taxable income. Note these boxes down and see what changes you can make in your life that would lead to drastic savings on taxes. The hourly you’ll earn from the money saved over the time spent will be well worth it and likely much higher than your salary, as you’ll be able to apply the knowledge and strategies through each tax year.

While a tax accountant may help minimize taxes given what happened during the year, as well as offer some common tax saving strategies, they are not going to be able to provide a comprehensive list of strategies, which you will gain from doing the above exercise.