So, let’s talk taxes. I’ll admit this is not the sexiest topic for me. But it is important. If you pay taxes, there are a few basics that I really think you should know. And I’ve laid them out for you below.
Here’s a list of common questions that I think you will benefit from by knowing the answers.
How much of your income is taxed?
Uncle Sam requires you to list almost all of your income on your tax return. However, not all of that income “counts” for taxes. Meaning that you must report all of your income, but you won’t pay taxes on all of your income.
To determine your “taxable income” (i.e. the money that you will pay taxes on, do the following:
- Start by calculating your gross income (i.e. almost all of your income that I just mentioned)
- Subtract “above the line deductions” (e.g.: moving expenses within certain limits and interest from investment accounts).
- This gives you your “adjusted gross income” (AGI).
- Subtract “below the line deductions” from AGI. Your below the line deductions will either be 1) a standard deduction or 2) itemized deductions. Every year the IRS adjusts the standard deduction. In 2016, the standard deduction is $6,300. This means that you can deduct $6,300 from your income and not pay taxes on it. Or, if you have itemized deductions that are higher than the standard deduction, you can deduct them to get an even greater deduction.
- Subtract an “exemption” amount, which is a specific dollar amount (set annually) multiplied by the number of people in your family. For example, if you are single in 2016, you can take a $4,000 exemption. If you are married, filing your taxes jointly with your spouse, you can take an $8,000 exemption.
- This gives you your taxable income.
Your taxable income is the amount that you will calculate the tax you owe. The difference between your AGI and your taxable income is money that you do not pay taxes on.
What is a marginal tax rate?
The United States operates on a progressive tax system, which means that people making less money pay a lower percentage than people making more money. The logic behind a progressive tax system is that wealthier people have a greater ability to pay taxes and therefore, should bear that burden.
The marginal tax rate is the tax rate for each level of income that you are taxed at. For the first X amount of dollars, you are taxed at Y. For the next XX amount of dollars you are taxed at YY. And so on.
For example, in 2016, if you are a married filing jointly taxpayer with a taxable income of $85,000, then you will pay the following in taxes on each portion of your income:
- 10% on the first $18,550 (= $1,855)
- 15% on $18,550-$75,300 (= $8,512.50)
- 25% on $75,300-$85,000 (= $2,425)
- TOTAL = $1,855 + $8,512.50 + $2,425 = $12,792.50
The marginal tax rate changes over time. For 2016, the rates for single tax payers and married filing joint tax payers are as follows:
If the charts above confuse you, you’re not alone! It’s nearly a consensus that the tax law in the United States is complicated and needs to be made simpler.
The take away here is that you should know is depending on your marital status and income, you may pay a lower tax rate on the first several thousand dollars and a higher rate above and beyond that. The more money you make, the more dollars will move into a higher tax bracket, and the more money you will have to pay Uncle Sam.
A big refund is nice when it comes, but what was the missed opportunity?
Who isn’t excited about a big tax refund? I know I am. But that’s because it feels like I’m getting money back that I didn’t otherwise have. This is actually not the truth.
Your tax refund is a check that the IRS is sending you because you overpaid – it’s a refund check.
What you owe in taxes is set before the year begins. It’s an exact percentage of your income. When you get a tax refund back, it means that you overpaid the government. Alternatively, when you owe money, you didn’t pay the government enough.
Why does this happen, then? Because of how you filled out your W-4 with your employer. You claim certain exemptions and your employer withholds a certain amount from your paycheck. If the amount that your employer withholds doesn’t match what you owe, the IRS will reconcile this come tax time.
The reason this is particularly bad is because of the “time value of money”, which is a fancy finance term that basically means the value of your money is worth more now than in the future because you could invest that money and earn interest on it. For example, if you get a $500 refund next year, that’s a flat $500. However, if you had that money throughout the year and didn’t have a tax refund, but instead invested the $500 and earned 6.0% on it, that money is now worth $530. That’s $30 you missed out on if you waited a year for the IRS.
However, just because you could earn interest on that money doesn’t mean you actually will. This is where you need to have good judgment and make the right decision for you. If you have trouble saving money, and you would actually put your refund in savings, then maybe it’s better for you to withhold more during the year and not earn interest on it. Bottom line – use your judgment and do what’s right for you.
A Final Note!
To get a better understanding of your taxes, review the Form 1040 that the IRS requires to be filed for individual taxpayers in the United States.
- Your taxable income is the amount that you owe taxes on (not your total income, or adjusted gross income).
- The United States uses a progressive tax system, which means that wealthier people pay more in taxes than people who make less money. You will pay a different percentage on each level of your income. As your income increases, so does your marginal tax rate. Use the marginal tax rates to determine what tax bracket you’re in.
- By receiving a tax refund, you overpaid the government. This money was yours to begin with and you may be better off adjusting your withholding so you have access to the money earlier (the time value of money matters).