How do Income Taxes Work?

School of Personal Finance Rich McCormack, CFP®

Hey, what's up everyone! Nobody likes to pay more income taxes than they need to, and the first step in achieving this is understanding how our tax system works. In this post, I'm going to walk you through a very simple example of how we pay taxes in this country. Let's get to it.

Our tax code is really just a system of incentives. The government pretty much lays out what they want you to be doing in order to pay less taxes.

For example, if you own a very large corporation and you employ a lot of people, you pay less in taxes. If you are a developer and you provide housing to many people, you pay less in taxes. Unfortunately, it is the everyday hardworking people who have W2 salaried positions that have very little wiggle room and very little opportunity to pay less in taxes.

How do income taxes work? Let's start with a simple example. Let's say we have a married couple, three children. They both have salary jobs, W2 incomes. They make $75,000 each. So altogether they make 150 grand. Some people who don't really know might just assume that they pay 22% on all of that income. Because if you look at our tax brackets making $150,000 would put you in the 22 percent tax bracket. You might think to yourself, well just take $150,000 and pay 22% of that. That's how much taxes you would owe for the year. But that is not at all how our tax system works. So for this example, let's make the assumption that they are contributing to their 401k plans. 401ks contributions come right off the top. So if they contribute in this example, $25,600 to their 401k's, that means that they're left with w2 wages of $124,400 that's what their w2 forms would add up to.

Now once we take that, that would be line 1 of their 1040 on their tax returns. After that they would add any other additional income that they would have to report. If you're self-employed or if you have capital gains and the other income rental income, all those things would have to be reported and they would get added to the w2 income. We are going to use $0 in this example. Then you would also have adjustments to income, things that could be subtracted from your income. Things like student loan interest or if you made an HSA contribution. If you have a high deductible health plan and you contribute to a health savings accounts or if you're eligible for a traditional IRA deduction that would be subtracted from your income. In this example, we are going to have zero for that, so no adjustments to income and that'll bring us down to our AGI, our adjusted gross income.

In this example, it's going to be the 120,400 and now once we get to this point, then we have either the standard deduction or we can itemize our deductions and we get to choose based on which one is more advantageous to us. For 2019 the standard deduction is $24,400. So in this example, it makes the numbers work out very nice. After the standard deduction, this couple is left with $100,000 of taxable income.

Now a lot of people make the assumption that if your taxable income is $100,000 that you have to pay 22% of that because you are in the 22% tax bracket. So you'd owe $22,000 bucks and call it a day. And that's it. But that's not how our tax brackets work. We have what's called a progressive tax system. So if we look at the tax brackets, the easiest way for me to explain this is that the money inside of each bracket gets taxed at that brackets rate.

2019 Income Tax Brackets School of Personal Finance

So if we look at the first bracket, $19,400 of your income is going to be taxed at that 10% rate. So that's 1,940 bucks. Then the income over that is going to get taxed at the 12% rate up to $78,950 so that would be $7,146 worth of tax. That's 12% of the amount that you've earned a both 19,400 and below 78,951 so all the money in that 12% tax bracket gets taxed at 12% and then if you still have more income, we moved down into the 22% tax bracket. So all these dollars or going are going to get taxed at 22% all the way up to $168,400 and now we just add up the amounts from each bracket that you would owe in taxes and that's how we get your total tax liability. So if you're in the 22% income tax bracket, that does not mean that all of your income is taxed at 22% that's why we call this a progressive tax system, because the first 19,400 is only taxed at 10% up to the next 78,009 50 it's only taxed at 12% and so on and so on and so on.

If you are in the 37% tax bracket, that does not mean that all of your money was taxed at 37%, you were subject to each of these brackets going through progressively. That's how our tax system works. So you add up the amount of tax liability for each bracket, and that's how we get the total amount of taxes that you owe. Now this is before we get to any credits that you might have available to you, like the child credit, which is now increased from 1000 to $2,000 for each child that you have. That is an amazing credit. Having three children, I was able to get a $6,000 credit against my tax liability for 2018. That is a very nice credit to have. And they raised the income limitations on that so that it applies to a large majority of people out there. A tax credit is much more valuable than a tax deduction.

So for this very basic, plain vanilla example, they would owe $7,717 for taxes for the year. But now both of them are w2 two employees. They were having federal taxes withheld from their paychecks throughout the year. This is where we get into tax refunds. Now some people confuse tax refunds with actually how much you're paying in taxes, but it is not the same. The amount they owe in taxes is the $7,717 but if they had $17,717 withheld from their paychecks throughout the year, then they would get a refund of $10,000 back. If they chose to only have $4,717 withheld from their paycheck all year, then they would owe an additional $3,000 in taxes at tax time. So the amount of your refund or the amount that you owe every year just depends on how much you were actually having withheld compared to how much tax you actually owe.

So again, in this example, the amount that they owe is not changing. They owe that amount no matter what. What they have control over is how much is actually withheld from their paychecks every two weeks or however often they get paid. So if they choose to have a large amount of money withheld from their paychecks every year, then obviously they're getting less money in every paycheck cause more of it is being withheld, but they're going to get a larger refund back. Where if instead, if they choose to have a very small amount withheld, then they might end up owing money at tax time. But the actual tax liability, the $7,717 that is not impacted by the amount of their withholding, they owe that money no matter what. It's just a matter of if they have more or less with held throughout the year, that's going to directly impacted the amount of their refund or the amount that they owe when tax time comes.

The biggest takeaway that I want you to understand here is that you pay less taxes when you are a large business owner that is selling stock because of capital gains or if you are a professional investor, if you are investing in large apartment complexes or rental real estate or large businesses, stocks, all of that stuff, it is taxed at lower rates. That is why Warren buffet famously pays a lower tax rate on his income than his secretary does because Warren Buffett is an investor. He is paying capital gains rates where his secretary earns ordinary income and she is going against these brackets. She's paying ordinary income tax rates on the money that she earns, and when you are a w2 employee, there is very little room for you to reduce your taxable income. You can max out 401ks. You could contribute to IRAs if you're eligible for the deduction. You could contribute to HSA accounts if you're eligible if you have a high deductible health plan. Other than that, there's not many ways to reduce your taxable income each year.

All right, that's it for this one. Hopefully that was easy to follow along and you learn something from this. Make sure to check out the YouTube video below to watch the visuals. I will see you again in the next post. Thanks!!