How do income taxes work?
The United States uses a progressive tax system that increases an individual’s taxes owed as their income increases.
In other words, the higher your income, the higher percentage of income tax you’ll pay. Understanding how this system works and which tax bracket you are in is critical for efficient personal tax planning.
Death and taxes.
They are commonly cited as inevitabilities.
Since they’re both unavoidable and I don’t really want to write about death, let’s talk income taxes, shall we?
What follows is a post that will hopefully take some of the mystery and headache out of understanding the income tax system in the United States.
Although taxes can be somewhat complex, the reason we’re covering them is pretty simple.
For the average American, federal income taxes account for 13.29% of annual income. FICA (social security and Medicare) add another 7.65%, for a combined total of just under 20%.
Obviously, income taxes are a major expense.
Understanding them thoroughly can present a great opportunity to save and plan in an effort to minimize the annual tax bite.
What is an income tax?
Each April, all Americans with income are required to submit income tax returns in which they’ll report their earnings, expenses, marital/parental status, gifts, deductions, and other related tax information to the Internal Revenue Service or IRS.
You probably already knew that.
If you did, then you also know that income taxes can be quite complicated.
The IRS has published over 800 different tax forms for Americans to use in the preparation of their income taxes; all designed to make sure everyone pays their legal share.
Ultimately, a tax return walks taxpayers through a series of income-related questions, followed by a series of expense or deduction-related questions, to arrive at a calculated taxable income.
That taxable income amount is then referenced in a tax table (known as Tax and Earned Income Credit Tables) that provides the amount of actual tax owed for the year.
If your income is over $100,000, you get to calculate your income taxes using a computation worksheet.
Tax Evasion Vs Tax Avoidance
Given that taxpayers are responsible for reporting, calculating, and submitting their own income taxes each year, one can easily see the potential conflicts of interest that might arise.
I don’t believe I’ve ever met anyone that enjoys paying income taxes.
It’s rather unpleasant to have to fork over a portion of your hard-earned income and even less enjoyable to go through the arduous process of tabulating your own bill.
Somehow, it seems akin to choosing the rope for your own hanging.
Yet, since we don’t have a choice, we might as well make the best of it for ourselves, right? If there are ways to avoid paying more income taxes, we should seek those out.
What follows is a brief description of the differences between tax avoidance and tax evasion and why understanding the difference can keep you out of prison.
Tax Evasion
Simply put, tax evasion is the use of illegal means in an effort to avoid paying taxes. Tax evasion is often seen in the form of individuals or companies lying about their income.
For example, a business owner who fails to record revenue in order to avoid paying tax on it or a company that uses creative accounting methods to calculate and report revenue to the IRS would both be guilty of evasion.
Given the IRS’ ability to fully audit one’s tax returns and seize property for any evasive tax reporting, it’s not a good idea to try and cheat on your income taxes.
Tax Avoidance
Tax avoidance, on the other hand, is the use of legal means to reduce one’s income taxes and is a key strategy for wealth building and preservation.
We noted from the outset that federal taxes alone represent a net cost of almost 20% of the average American’s annual income.
It’s completely reasonable to use any legal strategy available to reduce this cost.
In fact, in 1935 while serving on the 2ND Circuit U.S. Court of Appeals and ruling in the case of Gregory v. Helvering, Judge Learned Hand is famous for presenting the following quote in his judgment:
“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”
– Judge Learned Hand
To carry out tax avoidance strategies effectively, we need to know what the important components of boundaries are.
Let’s walk through several important tax concepts at a high level for your edification.
As time goes on, we’ll add and link more helpful posts to assist you in building your own tax reduction strategies.
Income
Establishing and calculating income is the first step in completing annual income tax returns.
After filling out some basic personal information about you and perhaps your spouse, form 1040 asks a series of questions about the income you’ve earned over the year.
This could be wages from a job, interest from savings accounts, dividend income from investments, capital gains from the sale of a home or business, and many other potential sources.
As you walk through this process, you’ll get two key numbers:
- Adjusted Gross Income (AGI) – This is your gross income minus any adjustments to income and is used to determine whether or not you qualify for certain deductions and/or credits. It’s also used by many states for determining state-owed income tax.
- Modified Adjusted Gross Income (MAGI) – MAGI is your AGI with certain income added back in. Like AGI, MAGI is used to calculate eligibility for certain deductions and credits, as well as eligibility for IRAs and Medicare Premium calculations.
- Taxable Income – This is line 15 on form 1040 and is used to calculate line 16: your total tax before applicable credits.
It’s important to understand income because income is the primary driver for determining what tax you’ll owe.
For most of your life, you probably won’t have much ability to control this and even less interest in keeping it low.
However, in your retirement years having control over the income side of the tax equation can provide an enormous benefit by providing some ability to limit or avoid income taxes altogether.
These strategies are discussed in Milestones six, eight, and nine on the Next Dollar Roadmap.
I’ll also add that income is the primary source of tax revenue in the United States (41.1% in 2020. 65.9% if you include FICA which is also taxed out of your income).
For better or worse, income is the focal point of federal taxation.
As a result, having control over income gives one the greatest amount of control over one’s income taxes.
The more you can manipulate your income, the more control you’ll have over the income taxes you pay.
Expenses/Deductions
As part of your income calculation, you’ll be given the opportunity to accept a standard tax deduction, known as the Standard Deduction (obvious, but at least it’s easy to follow), or itemize your deductions using Schedule A.
The standard deduction amounts for 2023 are $13,850 for single filers, $27,700 for married filing jointly, and $20,800 for heads of household.
Itemized deductions give you the opportunity to deduct or subtract certain expenses from your taxable income.
Some common examples include medical expenses, local & state taxes, mortgage interest, and donations to charity.
Deductions (standard or itemized) directly reduce the amount of income you have exposed to taxes.
For example, if you’re single and your gross income is $85,000, the standard deduction would reduce your taxable income by $13,850 to $71,150.
As a result, you would be taxed as if you had an income of $71,150 instead of $85,000 which means you’ll owe less tax.
This also means if the total of your tax deductions that can be itemized exceeds the standard deduction for your personal filing status, you should itemize your taxes to further reduce your taxable income.
Tax Credits
In addition to deductions, there are certain tax credits available to filers. Tax credits are particularly valuable because they represent a dollar-for-dollar credit against your total tax bill.
Some common credits include: the child tax credit, lifetime learning credit, adoption credit, earned income tax credit, and the American opportunity tax credit.
For example, in 2023 the child tax credit is $2,000 per child ages 0-5 and $3,000 per child ages 6-17.
Meaning if your total tax owed was $10,000 and you have 3 minor children 0-5 who are dependents on your taxes, you’d owe $4,000 instead.
Deductions, on the other hand, are subtracted from your taxable income before the total tax is calculated.
This makes a deduction less valuable than a credit because only a portion of your income is taxable.
Cathy Credit vs Debbie Deduction
To illustrate the difference between a credit and a deduction, let’s look at two hypothetical scenarios.
Cathy Credit and Debbie Deduction are coworkers and have identical salaries of $85,000 each. They are both single filers.
Cathy Credit files using the standard deduction of $12,950 and has one child for which she receives an additional $2,000 child tax credit.
Debbie Deduction has no children, but gives to charity and claims a mortgage interest deduction that allows her to claim itemized deductions totaling $15,000.
Here is a summary of each lady’s tax situation:
Cathy Credit | Debbie Deduction | |
Income | $ 85,000.00 | $ 85,000.00 |
Deductions | $ (13,850.00) | $ (15,000.00) |
Taxable Income | $ 71,150.00 | $ 70,000.00 |
Tax (from tables) | $ 11,276.00 | $ 11,023.00 |
Tax Credits | $ (2,000.00) | $ – |
Total Owed | $ 9,276.00 | $ 11,023.00 |
As you can see, Cathy’s credit is worth $1,747 more than Debbie’s deduction because they are a direct credit to income taxes owed.
Withholding
As you know, your employer withholds a certain portion of your income from each paycheck for taxes.
Once you’ve calculated all the income, deductions, and credits, you’ll compare that to what has already been submitted to the IRS.
The difference is what you still owe or what you’ll receive as a refund for overpaying.
The amount your employer withholds depends largely on how you complete form W-4 upon your employment.
Form W-4 allows you to communicate certain tax aspects to your employer so they can more accurately calculate what percentage of your paycheck should be withheld for income taxes.
You can resubmit form W-4 at any time, but you should not attempt to reduce your withholding below the suggested calculated amount.
If you owe too much in income tax at the end of the tax year, you’ll have to pay a penalty in addition to any tax owed.
Ideally, you want your withholding to match the actual tax you owe exactly, but that would be pretty difficult to do.
Instead, I recommend forecasting your taxes to the best of your ability, then adjusting your W-4 so that slightly more is withheld each month than you think you’ll need.
This ensures you’ll pay all the taxes you owe without any penalties or providing the government with an interest-free loan until next April.
