• Daniel Snitkovskiy

All You Need to Know About Personal Income Taxes

As the famous saying goes: "...in this world nothing can be said to be certain except death and taxes" (quoted from Ben Franklin, but the original could be earlier). The U.S. tax system is notoriously convoluted, so finding out what you need to be able to pay your taxes can seem especially daunting. This article is meant to lay the foundation for understanding the U.S. income tax system so you can use your newfound knowledge to begin saving money on taxes legally. (please don't evade taxes 🚔)


🇺🇸 U.S. Income Tax System in a Nutshell

Income taxes in the U.S. are a self-assessment based system, which means that it's on the taxpayer (i.e. you) to figure out how much you owe in taxes and pay accordingly [1]. Taxes on income is assessed on a yearly basis, and are paid in 2 main ways [2]:

  • Withholding: When you first join a company, you'll likely fill out a W-4 form, which essentially tells the employer how much of your paycheck to withhold. That is, a portion of your paycheck gets sent directly to the government on your behalf to go towards your expected personal income tax bill at the end of the year. [3]

  • Yearly Tax Return: After you finish off a particular year (e.g. 2019), you'll need to file an income tax return the following year (e.g. 2020). This is the "self-assessment", where you figure out how much you owe in income taxes. If you ended up paying more than the amount you actually owe (e.g. withholding), then the government owes you a check (refund). Otherwise, you owe the government a check (remaining tax liability).

In the following sections, we'll dive deeper into necessary concepts that'll help you in calculating your personal income tax!


[1] For an alternative to self-assessment, check out return-free filing.

[2] This article focuses on traditional employment; there will be notable differences if you are self-employed.

[3] Withholding is the main portion that goes towards taxes on a paycheck-basis, but there are other pay-as-you go taxes outside of this, like payroll taxes.


💵 Income Taxes - The Bare Bones


In this section, we get clear on what income means, who you pay your taxes to, and how to calculate income tax liability. To simplify the discussion, we'll omit tax incentives (i.e. credits/deductions), and add them back in in the following section once we have a good handle on the basics.


What does "income" even mean?

Income, in the broadest sense, is just money you receive within a given year. This money can come from many sources, and the type of income will affect the way in which it's taxed. There are 2 main types of income to be aware of:

  • Earned Income: This is income generated from working (e.g. wages, sick pay, etc.). This doesn't just include traditional work, but can be other earned money such as scholarships/fellowship grants.

  • Unearned Income: This is income that you don't work for, and is usually a result of "putting your money to work" (e.g. interest, dividends, royalties, and profits from selling an asset).

Where does my tax money go?

How much you pay in taxes is often a function of who you're paying your taxes to, which is a function of where you live. The geographic area that determines which taxes you pay is called a tax jurisdiction, and the jurisdictions typically fall into 2 buckets:

  • Federal: Everyone in the U.S. has to pay Federal Income Taxes. The money goes to the Internal Revenue Service (IRS) and is used to national programs like national defense, social programs, and national debt.

  • State/Local: Most states (except for 9) have State Income Taxes that get paid to the state governments. Within those states, there can be varying levels of Local Income Taxes (e.g. at the County, Municipality, or even School District level). Both state and local income taxes are commonly referred to as SALT (State And Local Tax) and are good to keep in mind since they can lower your Federal tax bill.

Though many of the concepts we'll be talking about today will mostly be about Federal Income Taxes, many concepts will apply to SALT, but the specific rules may be different jurisdiction-to-jurisdiction.


How much do I owe in taxes?

Most tax jurisdictions (most notably, Federal) use a Progressive Tax System (PTS). The core idea behind a PTS is to tax people who make more money at a higher rate than those who make less. This is accomplished by bucketing income (e.g. dollar $0 - $100, dollar $101 - $500, etc.), and taxing the higher buckets at a higher rate than the lower buckets (e.g. 2% for $0 - $100, 5% for $101 - $500, etc.). In tax jargon, the buckets are called tax brackets, and each tax bracket has a corresponding tax rate attached to it. Let's step through an example to see how we can calculate income tax liability within the Federal PTS!


Meet Kaleb, they're single, and they made $80,000 in 2020. Let's assume all of this is taxable [4], and use the tax brackets for the 2020 tax year associated with single tax filers [5]. In this case, they'd pay 10% on dollar $0-$9875 ($987.5), 12% on dollar $9876-$40,125 ($3,629.88), and 22% on dollar $40,126-$80,000 ($8,772.28), which comes out to a total of $13,389.66 [6]. One thing to note is that just because Kaleb's highest tax rate (also called marginal tax rate) was 22%, that's not the actual % of their taxable income that goes to taxes. The actual % is called the effective tax rate, which is calculated by dividing tax liability by taxable income (for Kaleb, that's $13,389.66 /$80,000 = ~17%).


[4] We'll refine this in the next section when we get into AGI.

[5] This is Kaleb's filing status, and it's used to determine which tax brackets apply. Other common statuses include married and head-of-household.

[6] You can often skip having to do this calculation if you use a tax table.


🍩 Income Taxes + Incentives

There are definitely ways to tweak aspects of your income to lower your tax liability (e.g. waiting at least a year before selling a stock), but the bulk of the "tax game" is in tax incentives (i.e. deductions/credits) which are specifically designed to reward government-sponsored behavior with lower tax liability.


Lowering Taxable Income → Deductions

In "How much do I owe in taxes?", we assumed that all of the income that Kaleb made was taxable, but that's not quite right. The total income that Kaleb made was actually their Gross Income (GI), and Deductions are expenses that can be subtracted from your GI to get the actual taxable income (TI) that's used to calculate your tax liability.


We can think of determining taxable income as a 2-step process:

  1. GI → AGI: AGI is your "Adjusted Gross Income", and is calculated by subtracting above-the-line deductions from your GI. One example of above-the-line deductions includes contributions to certain tax-advantaged accounts (e.g. traditional IRA or HSA) [7].

  2. AGI → TI: Once you calculate AGI, then you make the choice between taking the standard deduction (flat-rate based on filing status) or a series of itemized deductions (specific expenses, from medical to charitable contributions). Since you can only choose one, the optimal choice will be the one that is largest, since it'll also lower your AGI by the most.

Let's go back to the example of Kaleb. Let's say they made a $4K contribution to their 401(k) and opted for the standard deduction. Single Kaleb for the 2020 tax year has a standard deduction of $12,400. The 401(k) contribution would be taken out of their GI to get their AGI: $80,000 - $4,000 = $76,000. From there, we'll deduct the standard deduction to get their TI: $76,000 - $12,400 = $63,600.


We went from $80,000 to $63,600, which is $16,400 less in taxable income! Since Kaleb's marginal tax rate was 22%, that's $16,400 * 0.22 = $3,608 less in tax liability. 😃


[7] Above-the-line deductions also include pre-tax contributions (e.g. to a 401(k)). Sometimes there's a distinction between above-the-line and pre-tax, because you don't have to report pre-tax contributions on your tax returns to receive them, but we'll bucket them into the same category for simplicity.


Lowering Tax Liability → Credits

With Deductions, we lowered our tax liability indirectly by lowering our taxable income. Tax Credits take a more direct approach: they reduce the amount of tax you owe dollar-for-dollar. I.e, if our tax liability comes out to $500 and we apply a credit of $25, that brings our tax liability down to $500 - $25 = $475.


After calculating taxable income with deductions (from the previous section), Kaleb has a total tax liability of $9,781.66. Against this, Kaleb can begin applying tax credits to lower their tax bill. Let's say Kaleb also had a child (single parent) [8]. They could claim the Child Tax Credit for $2000, knocking their tax liability down to $7,781.66.


Some tax credits are refundable, which means that if the credit is more than you owe, you'll be eligible for a refund of the difference! Let's say Kaleb's tax liability was actually $1,000 before the tax credit was applied. The Child Tax Credit is refundable up to $1400. Since the credit is over our tax bill by $1000, we'll get those $1000 back as a check from the government! 😃


[8] Technically this would mean Kaleb could file as head of household, but would basically only change (a) standard deduction and (b) tax bracket calculations.


Qualifying for Tax Incentives

Though each deduction/credit will come with its own set of qualifications, one of the most common qualification is based on income. Most (if not all) tax incentives operate on an income phase-out basis. That is, as you climb in income, you qualify for fewer and fewer deductions/credits. This makes sense: taxes are a real burden for people in lower-income brackets, so it's reasonable to give them more help [9].


The 2 most common definitions of "income" that the IRS uses when determining income qualification are:

  • Adjusted Gross Income (AGI): We saw this in our discussion on deductions. This number affects a wide range of credits (e.g. Earned Income Credit for lower-income tax filers) and deductions (e.g. how much you can deduct in medical expenses).

  • Modified Adjusted Gross Income (MAGI): Modifies AGI by adding back in certain items like foreign earned income or tax-exempt interest (e.g. student loans). This determines a different set of tax incentives you may qualify for (e.g. health premium tax credits, whether or not you can deduct traditional IRA contributions, etc.) [10].

[9] As you get a higher and higher income, there are opposite rules, like the Alternative Minimum Tax, which are guard-rails to make sure wealthy people pay their fair share.

[10] MAGI and AGI can sometimes be the same, but if they aren't, MAGI will always be larger, since you're "adding back" things to your AGI.


Some Tax Incentives for College Students

There are many tax incentives that young people, depending on their circumstances, will qualify for. We'll call out some of the main ones as they pertain to college students so that anyone who's still in school can help mitigate one of the largest expenses you'll ever have [11]:

  • American Opportunity Tax Credit: This offers up to $2.5K in credits for those pursuing a bachelor's or other similar credentials. Those claiming the benefit must have a MAGI less than $90K (filing as single) to claim any benefit. A similar credit for graduate school is the lifetime learning credit.

  • Student Loan Interest Deduction: This is an above-the-line deduction that allows you to deduct up to $2.5K from your gross income. Those claiming the deduction must have a MAGI less than $80K (filing as single) to claim any benefit.

  • Scholarships/Fellowships: If you get a scholarship from a legitimate educational institution (e.g. universities) and the money is only meant for qualified education expenses (i.e. not room/board), then that income can be considered tax free.

[11] For more incentives related to education, see this IRS guide.


Conclusion

If you've made it this far in the article, congratulations 👏. Taxes are definitely the "eat your vegetables" of personal finances in many ways, but really come down to a series of rules and forms. Like many of the facets of personal finance, taxes will be a life-long learning journey as your personal situation changes, bringing different personal circumstances with different tax consequences. Hopefully, this article gives you the confidence to comb through the IRS website and be able to make decisions that'll help you maximize your take-home pay come tax season. 🙌


Action-Items

Since the bulk of the tax game lies in knowing the incentives, a great first step is to explore the credits/deductions listed on the IRS website to find those that might pertain to your specific situation [12]! Here are a few ideas:

  • Currently in post-K-12 school? Take a deeper dive into the previous section on tax incentives for college students to see which of those incentives you qualify for.

  • Have Investments in non-retirement accounts? If you experienced capital losses (i.e. selling assets for less than you bought them for), you can claim those losses as above-the-line deductions to lower your AGI! This is essentially the basis for tax-loss harvesting, which is one of the key selling points for most robo-advisors 🤖.

  • Have to pay SALT taxes? See how much you could save in itemized deductions if you claimed State/Local income (or sales!) taxes.

[12] Bias towards reading articles published by the IRS or summaries published within the past year or so because the Tax Cuts and Jobs Act changed a lot about the U.S. tax code.


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Disclaimer: The content on Young, Not Broke is for informational and educational purposes only and should not be construed as professional financial advice. Should you need such advice, consult a licensed financial or tax advisor.


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