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How Much am I Paying in Taxes?

How Much am I Paying in Taxes?

Client Question:  How much am I paying in taxes?

Advisor Answer:  In case you are not familiar, the picture above depicts the “Boston Tea Party” where American colonists dumped 342 chests of British tea into the harbor to oppose taxation without representation.  Not coincidentally, this occurred on December 16th, 1773, which was just three years before the Declaration of Independence.

Assuming you are an individual tax payer, the simplest answer to this question is to look at line 63 (titled “total tax”) of your US individual income tax return (Form 1040).  Some people may be surprised to find that this number is so high considering they often receive “tax refunds” at the end of the year; however, what often gets lost among W2 employees is that taxes are being withheld from their paychecks every pay period.  This means that your employer is sending part of your paycheck directly to the federal government before it ever reaches your bank account.

Line 64 of the 1040 shows the amount of money that has been withheld by your employer.  Often times, more taxes than necessary are withheld from one’s paycheck, which is why someone may be entitled to a refund at the end of the year.  It’s important to note that most individuals also owe income taxes to the states they live in, and they may even owe taxes to their cities and/or local municipalities.  The amounts of these taxes can be found on state and local tax returns.

What is my tax rate?

Many people I speak to believe they pay one tax rate on all of their income; however, this is a misunderstanding as it relates to Federal income taxes, which will likely comprise a vast majority of your tax payment.  Paying one tax rate on all of your income would be considered a “flat tax,” but the United States has a progressive income tax system where your tax rate will actually increase as your income increases.  This progressive income tax system results in a “marginal income tax bracket,” which you can see below.  This is from the College for Financial Planning®, and their helpful tax sheet can be found by clicking this link.

The first thing to note here is that income tax rates are applied to your “taxable income” as opposed to your salary or your “adjusted gross income.”  One of the biggest differences between your taxable income and adjusted gross income is that you deduct the greater of your total itemized deductions or standard deduction from your adjusted gross income to arrive at your taxable income.  Most of my clients default into the standard deduction, which is equal to $12,000 for single taxpayers and $24,000 for married tax payers filing jointly.

A quick example should provide clarification.  Let’s assume that John Doe has a salary of $100,000.  Assuming he doesn’t have any other income from investments or another job, John’s adjusted gross income is $100,000.  John takes the standard deduction of $12,000, so his taxable income is $88,000.  Now lets apply the progressive, marginal income tax rates above to John’s income of $88,000.

  • The first $9,525 of John’s income is taxed at 10%.  This results in a tax payment of $952.50.
  • The next $29,175 of income from $9,525.50 to $38,700 is taxed at 12% for another tax payment of $3,501, which results in a sum total of $4,453.50.
  • The next $43,800 of income from $38,700 to $82,500 is taxed at 22% for another tax payment of $9,636, which results in a sum total of $14,089.50.
  • The next $5,500 of income from $82,500 to $88,000 is taxed at 24% for another tax payment of $1,320, which results in a sum total of $15,409.50.

Given the information in the bullet points above, John’s marginal income tax rate is 24% because each additional dollar of income would be taxed at a 24% tax rate (at least until he earned above $157,500 of taxable income).  In contrast, his effective income tax rate is 15.41%, which is equal to the total tax payment of $15,409.50 divided by his adjusted gross income of $100,000.

How can I pay less in taxes?

  • Contribute to tax-deductible retirement accounts
    • Contributing to a traditional 401(k) or a traditional IRA (both pre-tax retirement accounts) would decrease your taxable income.  A lower taxable income would result in a smaller tax bill for a given year.  For example, if John Doe contributed $18,500 to his 401(k) plan (this is the maximum contribution for 2018) then his taxable income would be decreased by $18,500. The basic calculation of John’s tax bill with the savings from his 401(k) contribution is shown below:
      • Adjusted Gross Income of $100,000 – Standard Deduction of $12,000 – 401(k) contribution of $18,500 = Taxable Income of $69,500
      • Applying the tax table above, this would result in a tax bill of $11,229.50, which is $4,180 lower than John’s tax bill had he not contributed to his 401(k) plan
    • Pre-tax retirement plans such as a 401(k) also grow tax deferred, which means that any interest, dividends, or capital gains produced within the account would not be taxable to you.  The three aforementioned forms of income have their own unique tax rules that are different from the marginal income tax bracket shown above.
  • Contribute to Roth retirement accounts
    • While significant tax savings for pre-tax retirement accounts can be received in the same year as pre-tax contributions, the majority of tax savings for a Roth IRA will likely not be realized until the distant future. Roth IRA contributions are made “after-tax” instead of pre-tax; however, all distributions from a Roth IRA (including any gains/profits) are not taxed.  In contrast, all distributions from a pre-tax account are fully taxable at your ordinary income tax rate.  Like pre-tax accounts, any interest, dividends, or capital gains produced within the account would not be taxable to you.
    • It’s important to note that one should look at plan rules prior to taking distributions from retirement accounts as penalties can be assessed for early distributions.  A 10% penalty can be assessed on distributions from Traditional IRAs and Roth IRAs, if they are taken before reaching age 59.5.
  • Increase itemized deductions.
    • Itemized deductions include items such as interest expenses on a mortgage up to $750,000, property taxes, state income taxes, and charitable donations.  As you may recall from the discussion above pertaining to the standard deduction, tax payers will take the greater of their itemized deduction or their standard deduction.  This means that your itemized deductions would need to be greater than $12,000 for single filers or greater than $24,000 for married couples filing jointly.

Above are just three ways that one can reduce his or her taxable income; however, there are many other tax strategies that can help clients build greater wealth.  The decision of whether to contribute to a pre-tax or Roth retirement account is more complex than it may seem, and it should be based on an individual’s unique circumstance.

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