Top Ten Terms You Should Know About Taxes
Well, it’s that time of year again . . . time to file your taxes. Instead of another year of fumbling through your taxes and not really understanding what is going on with your money, this year I challenge you to increase your financial literacy and take control. You can start by better understanding these ten terms I think everyone should know about taxes.
If you are new to my blog or my FI Top Ten Series, the goal here is to increase financial literacy. I have chosen what I think are 10 of the most important terms you should know about a given area of personal finance. And today is obviously taxes.
Before we begin, please remember that I am not a licensed financial advisor, certified public accountant, or other financial professional. This is not professional advice and I recommend you consult with a licensed professional with regards to your own taxes. With that, let’s get started.
Witholding
Withholding is how much money you have withheld from your paychecks by your employer for income tax. Your employer then sends this money directly to the government. It’s basically a pay-as-you-earn way to pay your taxes, rather than having to come up with a large sum each year when taxes are due.
Whether you realize it or not, you actually have control over how much money is withheld from your paychecks. Note this is for income taxes, not payroll taxes like Social Security and Medicare. The only control you have over that is when you vote.
The amount withheld from each paycheck for income taxes is determined by what is on your W4 form submitted to your employer. On IRS form W4 you enter information regarding your filing status, number of dependents, income from other sources, any deductions you expect that will allow you to reduce your withholding, and extra money you may want withheld. This directly determines how much is withheld from your paychecks.
If you end up having to pay the IRS extra for income taxes each year come tax time and you don’t like that, adjust your W4 so more money is withheld. Conversely, if you get a large tax return each year and would prefer to have a smaller tax return and a little more money each paycheck, adjust your W4 so less money is withheld. And unlike open enrollment for health insurance that can only be done once a year for a limited period of time, you can adjust your withholdings on your W4 at any time during the year.
Filing Status
When filing your taxes you have to declare your filing status, which is largely based on your marital status. Your marital status on 12/31 for a given tax year is your marital status for that whole year (in the eyes of the IRS).
Filing status is important because it is used to determine your tax filing requirements, standard deduction, eligibility for certain tax credits, and most importantly the amount of tax you owe.
These are the four most common filing statuses:
- Single: taxpayers who aren’t married or who are divorced or legally separated under state law
- Married Filing Jointly: taxpayers who are married and wish to file their taxes together
- Married Filing Separately: taxpayers who are married but wish to file separate tax returns; reasons may include a smaller tax bill if filed this way or the couple wishes to only be responsible for their own tax and have separate finances
- Head of Household: usually a taxpayer that is not married but has paid more than half of household costs for themselves and at least one dependent person
Form 1040
IRS form 1040 is what everyone now uses to file their federal income taxes. Prior to the Tax Cuts and Jobs Act of 2017, you used to be able to choose to use form 1040, 1040A, or 1040EZ based on your tax situation. Now, there is just the one 1040 form that is only half a sheet of paper. Although this sounds like the process is much simpler, in my opinion it’s equally as complicated as it was before, just in a different way. Now there are up to six schedules you can attach to your Form 1040 based on your situation. A schedule is a form the IRS requires you to prepare in addition to your tax return for certain types of income or deductions. For the new form 1040 these include the following:
- Schedule 1, Additional Income and Adjustments to Income
- Schedule 2, Tax
- Schedule 3, Nonrefundable Credits
- Schedule 4, Other Taxes
- Schedule 5, Other Payments and Refundable Credits
- Schedule 6, Foreign Address and Third Party Designee
Note that these are just the six schedules with the new 1040 form. Other schedules that may apply to filing your taxes may include:
- Schedule A, Itemized Deductions
- Schedule B, Interest and Ordinary Dividends
- Schedule C, Profit or Loss from Business (Sole Proprietorship)
- Schedule D, Capital Gains and Losses
- Schedule E, Supplemental Income and Loss (includes rental and royalty income)
There are many more, but you get the point. As you can see, taxes can still get pretty complicated. So unless you really know what you are doing, I would strongly recommend a competent accountant or professional tax software.
Adjusted Gross Income (AGI)
Income is when you receive money. Your gross income is the sum total of money you receive from all possible sources including wages, interest earned, dividends received, rent from rental properties, profits from investments, sale of your home, gambling winnings, cash gifts, etc.
Adjusted gross income is your gross income minus adjustments allowable by the IRS. These adjustments may include qualified IRA contributions, moving expenses, alimony payments, certain business expenses, and student loan interest paid (their are rules regulating these adjustments that are beyond the scope of this blog post, ask your accountant).
These allowances are also known as “above the line” deductions because they come before the line on the tax form where AGI is calculated. Deductions listed after this line calculation on the tax form are often referred to as “below the line” deductions.”
Your AGI is extremely important for at least a few reasons.
First, it is the starting point to determine how much you owe in federal income taxes based on your filing status. Once you arrive at your AGI, you can choose to either take the standard deduction or itemize your deductions, further lowering your tax bill (we will discuss these below). This will ultimately result in a dollar amount that is your taxable income, which determines how much you owe in taxes.
Second, your AGI helps determine your eligibility for certain tax credits and tax deductions.
Third, most states with income tax also use your AGI as a starting point, so you’ll need it for filing your state income taxes as well.
In addition to AGI, you may also hear the term modified adjusted gross income (MAGI). Your MAGI is a number the IRS uses to see if you qualify for certain tax breaks. To calculate your MAGI, you take your AGI and add back in certain adjustments such as any IRA or student loan interest deductions. Talk with your accountant about the specifics of your MAGI and what it means for you.
Marginal Tax Rate
Your marginal tax rate is how much of each additional dollar of income that you earn is owed in income tax. This is one of the most commonly misunderstood concepts in taxes. Most people understand that they are in a certain tax bracket based on their income. For example, let’s say we have a married couple filing their taxes jointly who has a taxable income of $75,000 in 2019. They do a Google search to see what their tax bracket is and find the following table:
Based on this information, they see that they fall under the 12% tax bracket, which ranges from $19,401 to $78,950 for those married and filing jointly for 2019. Based on this they figure out that they would owe $9,000 in federal income tax, since 0.12 x $75,000 is $9,000. They are also really glad they didn’t get that $5,000 bonus this year because that would have made their taxable income $80,000, pushing them into the next tax bracket which is 22%, a 10% increase. This would have made their tax bill 0.22 x $80,000, which is $17,600, nearly double what it was if they only made $75,000! Wow, they really dodged the proverbial tax bullet there . . . except they didn’t. This couple’s entire thought process (which is how many Americans think about taxes) is completely wrong, and thus all the numbers we just calculated, are also completely wrong. Let’s discuss why.
In the Unites States our tax system is a progressive taxation system, which means people are taxed on a progressive scale. I think the best way to understand this is with an example.
Let’s say we have a very successful young software engineer who has a taxable income of $200,000 in 2019. We will assume she is not married and her filing status is single. Referring to the above table, her taxes would be calculated as follows:
- The first $9,700 of income she makes is taxed at 10%, so 0.10 x $9,700 = $970.00
- The next $29,775 of income (which is $39,475-$9,700) is taxed at 12%, so 0.12 x $29,775 = $3,573.00
- The next $44,724 of income (which is $84,200-$39,475) is taxed at 22%, so 0.22 x $44,724 = $9,839.50
- The next $76,525 of income (which is $160,725-$84,200) is taxed at 24%, so 0.24 x $76,525 = $18,366.00
- The next $39,275 of income (which is $200,000-$160,725) is taxed at 32%, so 0.32 x $39,275 = $12,568.00
- Her total tax liability is then $970.00 + $3,573.00 + $9,389.50 + $18,336.00 + $12,568.00 = $44,836.50
- The 35%, and 37% brackets would not apply since she does not earn this much money.
This example demonstrates how the percentage you owe in taxes increases based on how much you make, but not for the entire amount, only for the portion of income above the threshold for each tax bracket. This highest tax bracket for what you earn is what is called your marginal tax rate. Again, your marginal tax rate is how much of each additional dollar of income that you earn is owed in tax. For our software engineer, she would owe 32% of the next dollar she earns, and for every dollar after that until her taxable income reached $204,100. The next dollar after that would be taxed at 35% and so forth.
Back to our original couple that had a taxable income of $75,000. Since they are married filing jointly, the first $19,400 is taxed at 10%, which is $1,940. The next $55,600 is taxed at 12%, which is $6,672. Adding these two numbers together, their actual amount they owe in federal income tax is $8,612, which is less than the $9,000 they initially thought. And let’s say they did get that $5,000 bonus during the year, they would only owe 22% on the $1,050 above the $78,950 threshold for the 12% tax bracket, not the whole amount.
Effective Tax Rate
Your effective tax rate is essentially the average percentage of your income you are paying in income tax. This is determined by taking your total tax liability and dividing it by your taxable income.
Let’s use our above example of the software engineer. She has a total tax liability of $44,836.50.
If we take $44,836.50 and divide it by her total taxable income of $200,000, this gives us 0.224, which is an effective tax rate of 22.4%.
Now let’s talk some tax lingo. Our software engineer had a taxable income of $200,000 in 2019. Based on her single filing status, in 2019 her marginal tax rate is 32%. But based on the progressive taxation system in the U.S., her effective tax rate is actually 22.4%. See, you can do this.
I find that my effective tax rate is a very important number to know because it can help me with my overall financial plan. But I like to take it beyond just federal income tax and look at it from an overall tax burden perspective.
After my tax return last year I added up the final amount we paid in federal income tax, state income tax, Social Security, Medicare, and property taxes. Considering sales and other miscellaneous taxes, I estimate that our actual effective tax rate is around 40%. This is very important because I know moving forward that 40% of everything I earn will go towards taxes, allowing me to accurately make financial goals and plans accordingly. This is also a powerful demonstration of how heavily wages are taxed in our country compared to other sources of income such as real estate, capital gains, or dividends. As such, I am always looking for ways (legal ways) to reduce my overall tax burden. We will discuss four terms that reduce your taxable income next.
Tax Credit
Tax credits and tax deductions are often confused. A tax credit is better than a tax deduction. With a tax credit you can reduce the amount you owe in taxes dollar for dollar. This means if your tax bill is $2,000, but you get a $1,000 tax credit, you now only owe $1,000 in taxes. And with some tax credits, called refundable tax credits, if the credit exceeds the amount you owe in taxes, the IRS will actually send you a check for the difference. For example, if your tax bill was only $500 and you received a $1,000 refundable tax credit, you wouldn’t owe any taxes AND the IRS would actually send you a check for $500.
Common examples of tax credits include the Child Tax Credit, Premium Tax Credit, Child and Dependent Care Tax Credit, and Earned Income Tax Credit.
Tax Deduction
While tax deductions aren’t quite as good as tax credits, they’re still great because they can significantly reduce your overall tax burden. A tax deduction is an expense that the IRS allows you to subtract from your adjusted gross income (AGI), which effectively reduces the amount you owe in taxes. While you aren’t getting dollar for dollar back like a tax credit, you are reducing the amount you owe in taxes by the percentage of your marginal tax rate.
For example, let’s say your gross income for the year was $150,000.
Based on your situation and the allowed adjustments by the IRS, your adjusted gross income (AGI) is $130,000.
Next you have the option to subtract the greater of your standard deduction or itemized deductions (which we will discuss next). For simplicity we will assume you are married filing jointly and choose to take the standard deduction of $24,400 in 2019. This further reduces the amount you owe taxes on to $105,600. This is what is referred to as your taxable income, and is how much you owe taxes on.
This $24,400 deduction reduced taxable income from $130,000 to $105,600. Both these amounts fall in the 22% tax bracket for those that are married filing jointly. So if we take $24,400 x 0.22, we can see that this tax deduction would save $5,368 in taxes owed. As mentioned above, while it is not the dollar for dollar tax break that a tax credit would give you, it is still pretty great.
Common examples of tax deductions include charitable contributions, medical and dental expenses that exceed 7.5% of your AGI, and work related education expenses.
Standard Deduction
The standard deduction is the dollar amount that the IRS allows you to deduct from your AGI to arrive at your taxable income. This has the effect of reducing your overall tax bill by a significant amount. In essence, the government is saying that this is the amount that you can earn without owing federal income tax.
The standard deduction is a fixed amount and you don’t have to present any documentation for qualifying expenses to get it. It is solely based on your filing status for the given tax year. The dollar amounts for 2019 are listed below:
- Single: $12,200
- Married Filing Jointly: $24,400
- Married Filing Separately: $12,200
- Head of Household: $18,350
These amounts are significantly higher than they were several years ago. With the Tax Cuts and Jobs Act of 2017 the standard deduction was essentially doubled compared to previous years.
As mentioned above, when filing your taxes, you have to choose to take either the standard deduction or itemized deductions. The decision is based on whichever is greater, resulting in the lowest tax bill possible, and the IRS understands this. With the doubling of the standard deduction, many more people will likely choose the standard deduction instead of itemized deductions. This makes it simpler for these taxpayers since they no longer have to keep track of expenses that qualify for deductions. Likewise, it makes it simpler for the IRS to process tax returns.
Itemized Deductions
So what are itemized deductions? These are expenses on eligible products or services (as set by the IRS) that can be deducted from your AGI to reduce your taxable income. Common examples include charitable contributions, mortgage interest, medical and dental expenses, and state/local income and property taxes (be aware that rules and restrictions apply to these). Unlike the standard deduction, you will have to provide documentation of these expenses.
If the sum total of your itemized deductions is greater than the standard deduction, then it would make sense to choose this option on your tax return, since it would reduce your tax bill by a greater amount. With the doubling of the standard deduction, fewer people choose this option, especially since it can be a hassle to gather all the necessary documentation. However, if it can save you thousands of dollars, then in my opinion it is definitely worth it and this is what we do every year.
Conclusion
If you read through all this content, great job persevering to the end. Most people find taxes pretty boring and hard to understand. But if you make just a little bit of an effort to understand the basics, I believe it can put you in a much better position to take control of your financial destiny. And for most of us in this country, we spend more money on taxes than just about anything else. So doesn’t it make sense to try and understand the very thing you spend the most money on? It does to me.
Thanks for reading. I hope you are doing well in your progress towards reaching FI. If you have any questions or comments that might help other readers, please list them below. In the meantime, keeping working towards Freedom Through FI!
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