What You Absolutely Must Know About Taxes

If you had to describe taxes in one word, what would it be?  Hard? Complicated? Stressful? With a little bit of knowledge they can be much less so.  In this post we’ll demystify taxes by discussing the must-know tax terms related to federal taxes

Tax Liability

Tax liability is one of the most basic and most important terms to know.  It is simply the amount of taxes you responsible for paying. It is the amount of taxes you would owe if you had not paid any taxes throughout the year.

As an oversimplified example, if the federal tax rate is 20% and you made $50,000 in a year your tax liability would be $10,000.  This example ignores all other factors such as credits and deductions, which we discuss below.

Tax Return

A tax return is a statement of how much income you made, your tax liability, how much you’ve already paid in taxes, and a few other details regarding taxes.  This is the document you fill out (or have generated for you via software such as Turbotax) and then submit when you “file your taxes”.

Tax Refund

Yay!  Tax return time!  Free money! It’s just like Christmas… until you realize that you paid for all of your own gifts.  Here is how it works.

Once your tax return is submitted, if you’ve paid more in taxes than your liability you’ll receive the difference.  This is called a tax refund. If you have paid less than your liability you will owe money come tax time.

Using the example above, if your tax liability is $10,000 and you had $12,000 taken out of your paycheck over the course of the year, then you have overpaid and will receive a $2,000 refund.  If you had only paid $9,000 over the course of the year then you would owe an additional $1,000.

Many people are excited for tax time to get this refund and view it as “free money from the government”, but in reality this was your money all along and is just a refund because you overpaid on your taxes.  It is equivalent to giving the government a tax free loan. On the flip side, if you underpaid on your taxes that means you had larger paychecks, but will owe the government money at tax time. This is essentially you getting an interest free loan from the government, but most people don’t want to have a tax bill at the end of the year.  In general I try to come as close to paying the correct amount on my paycheck as possible in order to maximize my take home pay without having to owe more come tax time. If you are bad with being able to constantly save money without dipping into it, then having a tax refund can be a good way to pay down debt or cover large expenses. Basically using the government as a savings account that you can’t be tempted to withdraw from, albeit without any interest.

Filing Status

Your filing status is used to determine how your taxes are calculated and are based on your marital and family situation.  There are five filing statuses: single, married filing jointly, married filing separately, head of household, and qualifying widow(er) with dependent child.

Let’s talk about the easy ones first.  If you are married you will either file as “married filing jointly” or “married filing separately”.  You would qualify for either. You simply pick which will reduce your taxes the most. This is usually filing jointly, but there are some scenarios where that may not be true.  Tax software or a tax professional can help you make this decision.

For most non-married people filing as a single will be the only option.  There are specific requirements for the other two statuses. If you don’t qualify for either of them and are unmarried you will file in this way.

To qualify for head of household you must be unmarried, have a dependent who lived with you for at least half the year, and pay for over half the cost of maintaining the home.

To be a qualifying widow(er) with a dependent child you have to have qualifying dependents have had your spouse pass during either of the two preceding tax years, and not have remarried.  After the two year time period you may file as head of household.

There are several nitty-gritty rules and qualifications for each filing status, but this covers the basics.  If you aren’t sure which status you should file as a tax professional or tax software can help.

Adjusted Gross Income (AGI)

AGI is simply your total income including wages, salary, taxable interest, dividends, capital gains, etc. minus a few specific deductions including student loan interest, moving costs, traditional IRA contributions, and a few others.

Your AGI is used for determining if you qualify for certain deductions and credits and for calculating your tax liability.

Pre-tax deductions such as an employer sponsored health insurance plan will reduce the total income reported on your W-2 so, when calculating your AGI, be sure to use the gross income on your W-2 (if applicable) and not your base salary.

Let’s continue building on our prior example.  If your base salary is $50,000 and you have $5,000 a year deducted from your paycheck for an employer sponsored health plan, then your income reported on your W-2 would be $45,000.  If you paid $1,000 in student loan interest then that would be subtracted from your income making your AGI $44,000.

Taxable Income

Your taxable income is your AGI minus either your itemized deductions or the standard deduction.  Both of these are explained below. Your taxable income is the number that will be used along with the tax rates to help calculate your tax liability.

Deduction

We’ve talked about deductions a little bit already.  All a deduction does is reduce your taxable income or, in some specific cases, lowers your AGI. A lowered AGI reduces your taxable income.

If your AGI is $44,000 as mentioned above, and you have an additional $14,000 of deductions then your taxable income would be $30,000.

It’s extremely important to remember that a deduction amount is not the reduction amount of your tax liability, it is the reduction amount of your taxable income.  For example, if you have a $2,000 deduction, it will not be $2,000 less you owe in taxes, it reduces your taxable income by $2,000 which then will reduce your liability by an amount based on your tax rate.

Standard Deduction

The standard deduction is a set amount of money that you can deduct to reduce your taxable income based on your filing status.  If you take the standard deduction you are not able to take other deductions aside from the ones which reduce your AGI (also called “above the line deductions”).  This makes filing your taxes much simpler. The 2018 standard deductions are as follows:

Tax Filing Status 2018 Standard Deduction
Single $12,000
Married Filing Separately $12,000
Married Filing Jointly $24,000
Head of Household $18,000

We can use this table to come up with a few examples.

If a single filer has an AGI of $44,000 and takes the standard deduction of $12,000 then their taxable income is $32,000.

If a married couple has an AGI of $44,000 and takes the standard deduction of $24,000 then their taxable income becomes $20,000.

Itemizing

There are many deductions available to taxpayers that can reduce taxable income.  Some of the most popular ones include charitable donations, medical expenses, and mortgage interest, but there are many more.  A tax advisor or tax software can help you find all of them that are applicable for you.

You will only itemize if the sum of these deductions is greater than the standard deduction.  This is important to keep in mind. You may hear something like “don’t worry about it, it is tax deductible”.  This is misleading for a couple reasons. First, it is only deductible if you itemize.  Second, just because it is deductible doesn’t make it free.  If a $200 deduction is taken it just reduces your taxable income by $200.  That means if the tax rate is 20% then that deduction is only actually saving you $40 on your tax liability.  It is also important to remember that some deductions, such as the medical expense deduction, only kick in once you reach a certain dollar amount.  Tax software will automatically choose between itemizing and taking the standard deduction in order to minimize your tax liability.

Let’s take a look at another example.  If a single filer with an AGI of $44,000 has deductions that add up to $10,000 he should not take it and instead use the standard deduction of $12,000 for 2018 making his taxable income $32,000.

If the same filer instead has $14,000 worth of deduction he should itemize instead of taking the standard deduction.  This would make his taxable income $30,000.

Credit

A tax credit directly reduces your tax liability rather than reducing the taxable income.  If you have a $1,000 credit your liability will be $1,000 less. This makes a $1,000 tax credit far more valuable than a $1,000 tax deductible.  It is exactly as if you had already paid this amount toward taxes. It is credited toward your tax bill. Some of the most popular credits include the Earned Income Tax Credit, American Opportunity Tax Credit, and Child and Dependent Care Credit.

If a single tax filer has an AGI of $44,000 and takes the standard deduction to make his taxable income $32,000 and also has a flat tax rate of 20% he will have $6,400 worth of taxes.  If he also has a $1,000 credit, that makes his tax liability $5,400. If he payed $6,000 out of his paycheck for taxes over the course of the year he would be issued a $600 refund.

Refundable Credit

Certain credits are what is called “refundable”.  This means that they can actually take your tax liability below $0 which would allow you to get refunded for more than you actually paid in.  One example of this is the Child Tax Credit. It is $2,000- up to $1,400 of which is refundable. This means if your deductions already took you to a $0 liability, applying this credit would give you a $1,400 refund.  This is one of the only cases where you actually do get “free” (or rather, paid for by other taxpayers) money from the government.

Tax Bracket

In this post so far we have only mentioned flat tax rates for simplicity’s sake, but that isn’t how income tax is actually set up.  The tax rate you pay is actually based on your taxable income. Your rate also varies based on your filing status. Let’s have a look at the tax brackets for single filers.

Single Tax Filers
Taxable Income Tax Rate
$0 – $9,525 10%
$9,526 – $38,700 12%
$38,701 – $82,500 22%
$82,501 – $157,500 24%
$157,501 – $ $200,000 32%
$200,001 – $500,000 35%
$500,001 or more 37%

There are a few common misconceptions about these tax brackets.  Someone whose salary is $100,000 might think, “I make $100,000, so my tax bracket is 24%, so I will owe $24,000 in taxes”.  This isn’t at all the case. The first error is assuming that “your tax bracket” is based on your salary, when in reality it is based on your taxable income.  It could be the case that this person has $18,000 worth of pre-tax paycheck deductions, above the line deductions (those that affect AGI), and  other deductions (either itemized or the standard) which brings them down to $82,000 and his tax bracket down to 22%. The second error is assuming that all of your income gets taxed at the same rate.  In reality only the amount over the previous tax bracket is taxed at that rate. That means his tax breaks down like this:

$0 through $9,525 = $9,525 taxed at 10% = $952.50 +
$9,525 through $38,700 = $29,174 taxed at 12% = $3,501.00 +
$38,700 through $82,000 = $43,300 taxed at 22% = $9,526
Making a grand total of $13,979.50 which is over $10,000 less than what was assumed.

With this in mind we can rewrite the tax table to be easier to work with.  The tax on the first $9,525 for a single filer in 2018 will always be $952.50 regardless of how much they make. We can reference this constant number and not have to recalculate it. This means if a single filer is in the 12% tax bracket they will owe $952.50 plus 12% of whatever their taxable income is over $9,525.  In the same way, if you are in the 22% tax bracket then the amount owed from the second tax bracket will always be constant. $3,501 in this case. Which means the tax owed from the first two tax brackets combined will also be constant, in this case $4,453.50.  If we continue this pattern we get the following easy to use tax table.

Single Tax Filers
Taxable Income Taxes Owed (Before Credits)
$0 – $9,525 10%
$9,526 – $38,700 $952.50 + 12% of amount over $9,525
$38,701 – $82,500 $4,453.50 + 22% of amount over $38,700
$82,501 – $157,500 $14,089.50 + 24% of amount over $82,500
$157,501 – $200,000 $32,089.50 + 32% of amount over $157,000
$200,001 – $500,000 $45,689.50 + 35% of amount over $200,000
$500,001 or more $150,689.50 + 37% of amnt. over $500,000

Let’s use this table to calculate the tax owed for an individual filer with a taxable income of $60,000.  This makes the highest portion of the income in the 22% tax bracket, so we use:

$4,453.50 + 22% of the amount over $38,700 =
$4,453.50 + 22% * ($60,000 – $38,700) =
$4,453.50 + 22% * $21,300 =
$4,453.50 + $4,686.00 =
$9,139.50 owed

This method can be used for any amount of taxable income.  Below are the same easy to use tables for the remaining filing statuses so you can calculate the taxes for any status and taxable income.

Married Filing Jointly / Surviving Spouse
Taxable Income Taxes Owed (Before Credits)
$0 – $19,050 10%
$19,051 – $77,400 $1,905 + 12% of amount over $19,050
$77,401 – $165,000 $8,907 + 22% of amount over $77,400
$165,001 – $315,000 $28,179 + 24% of amount over $165,000
$315,001 – $400,000 $64,179 + 32% of amount over $315,000
$400,001 – $600,000 $91,379 + 35% of amount over $400,000
$600,001 or more $161,379 + 37% of amount over $600,000
Married Filing Separately
Taxable Income Taxes Owed (Before Credits)
$0 – $9,525 10%
$9,526 – $38,700 $952.50 + 12% of amount over $9,525
$38,701 – $82,500 $4,453.50 + 22% of amount over $38,700
$82,501 – $157,500 $14,089.50 + 24% of amount over $82,500
$157,501 – $200,000 $32,089.50 + 32% of amount over $157,000
$200,001 – $300,000 $45,689.50 + 35% of amount over $200,000
$300,001 or more $80,689.50 + 37% of amount over $300,000
Head of Household
Taxable Income Taxes Owed (Before Credits)
$0 – $13,600 10%
$13,601 – $51,800 $1,360 + 12% of amount over $13,600
$51,801 – $82,500 $5,944 + 22% of amount over $51,800
$82,501 – $157,500 $12,698 + 24% of amount over $82,500
$157,501 – $200,000 $30,698 + 32% of amount over $157,000
$200,001 – $500,000 $44,298 + 35% of amount over $200,000
$500,001 or more $149,298 + 37% of amount over $500,000

Withholding Allowance

If you want to adjust how much money is taken out of your paycheck so you get a larger/smaller refund or owe more/less money come tax time, the most common way is by adjusting the number of withholding allowances you claim.  The higher number you claim, the less withheld for taxes from each paycheck. This is helpful if your family is living off instant ramen to make ends meet from paycheck to paycheck, but are pulling in a massive tax return each year.  I generally try to have the total amount of taxes withheld throughout the year as close to my tax liability as possible. A tax return of $0 and owing nothing extra come tax time is the ultimate win in my book. That allows me to have the maximum amount of money on my paychecks without having a bill at the end of the year.  You normally enter this on your W-4 form when you first start working for an employer. If you need to change it after I recommend talking to your HR department to learn how. If you need help figuring out how many allowances you should claim check out this IRS calculator.

Additional Withholding

Additional withholding is exactly what it sounds like, an additional amount from your paycheck withheld for taxes.  If you want to have a specific amount of extra money withheld for taxes each paycheck, this is where you’d make that change.

Full Example

At this point you may be feeling overwhelmed.  Let’s do one final example using everything we’ve learned.

Take a married couple earning a combined $80,000.

$400 a month is taken from their paycheck per month ($4,800 a year) and they contribute $1,000 per month ($12,000 per year) to their employee-sponsored traditional (pre-tax) 401k.  They have no other pre-tax money taken from their check.
This makes their reported W-2 income $63,200.

They paid $3,000 for the year in student loan interest.  Because of this they will take an “above the line” deduction of $2,500 (this is the maximum allowable for student loan interest).  They have no other “above the line” deductions.
This makes their AGI $60,700.

They have various itemized deductions that add up to $18,000.  Since this is less than the standard deduction of $24,000 for a married couple they will take the standard deduction.
This makes their taxable income $36,700.

Looking at the tax bracket tables we can see this puts them in the 12% tax bracket, so before credits they will owe $1,905 + 12% of amount of taxable income over $19,050.
This gives us $1,905 + 12% * ($36,700 – $19,050), or $4,023.

They qualified for $2,000 in tax credits.
This takes their total tax liability to $2,023.

They had $300 withheld each month ($3,600 per year) from their paycheck for taxes.
Since they overpaid for taxes they will get the difference of $1,577 ($3,600 – $2,023) back as a refund when they file their tax return.

If they wanted to alter the amount withheld on their paychecks they can adjust their allowances or additional withholdings.

Conclusion

Hopefully you’ve found this information helpful and now have a deeper understanding of federal income tax.  Feel free to leave any questions, comments, or recommendations for future posts below and I’ll respond as soon as possible.  If you have any tax-paying friends you think would benefit, go ahead and click that share button.

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