Taxes are Simple. Mostly.

theInterest: Issue #3

Taxes are simple. Mostly.

I think most people should be able to roughly calculate their federal income taxes, fairly easily, on the back of an envelope. This is especially the case with changes to the tax code effective 2018. Being able to do a rough calculation is a skill that will help you be more aware of your money, better forecast your tax bill or refund, and to do some light weight tax planning.

The high level formula

income
- deductions
- adjustments
x rate
- credits
= taxes

Deductions (itemized OR standard)

The standard deduction is $12k for single filers and $24k for married filers. Unless your itemized deductions top that, this category is simple. This is where the meaty deduction are, such as mortgage interest, charitable contributions, property taxes, state and local taxes (all of which have limits), HOWEVER, you either itemize OR take the standard deduction. In 2018, the standard deduction got much larger (nearly doubled) meaning it’s going to be a lot more common to take it vs. itemizing. Yes, those charitable gifts and mortgage interest are most likely no longer saving you any money on taxes.

Adjustments (aka “above the line” deductions)

You can reduce your taxable income by a handful of things classified as “above the line” deductions, whether or not your itemize. Most commonly these are taken out of your paycheck, like health insurance premiums and retirement savings. For things not taken from your paycheck, the hardest part is just remembering if something is an above the line deduction or an itemized one. But you have the Internet for that and now you know what to search for. Here’s the list of above the line deductions (to arrive at “adjusted gross income”) straight from the source:

Tax rate

Your first portion of income is taxed at 10%, the next portion at 12%, the next portion at 22% and so on. It’s a common error to think all of your income is taxed at the same rate (whatever “your tax bracket” is), however that’s not true, it’s sliced into portions — everyone’s first portion of money is taxed at 10%, regardless of how much they make. Once you know your taxable income, figuring out your tax amount is a simple matter of multiplying by the tax rates for each portion or using a tax table.

Tax credits

*New for 2018* — as long as your income is less than $200k for single or $400k for married, you get a $2,000 tax credit per child under 17 via the Child Tax Credit. There are other credits, for education, low income, and other situations, but by far the most common is the Child Tax Credit.

Putting it all together

Let’s say you’re married with 2 kids, have $100k of income, contributed $3k to a retirement fund, paid $8k in mortgage interest, gave $5k to charity, and paid state local and property taxes of $8k.

$100k (total income)
- $3k (above the line adjustments)
- $24k (standard deduction)
= $73k taxable income
x tax rates (13,600 * 10% + 38,200 * 12% + 21,200 * 22%)
= $10,608 taxes before credits
- $4,000 tax credits
= $6,608 final tax amount (effective rate = 6.6%)

Notice the standard deduction was used instead of factoring in the mortgage, charity, and local taxes.

That refund tho

The amount you owe or are owed when you file your taxes is even simpler: your tax amount (the $6,608 above) minus what you’ve already paid via federal income tax withholdings from your paycheck throughout the year is what you owe, or, if that’s a negative number, it’s what they owe you. Withholdings tend to be conservative  — perhaps our example family of 4 paid $8k in taxes during the year, in which case they’d get a refund of $1,392 come tax time.

“Payroll taxes”

Also a federal tax, though not the income tax, are social security and medicare taxes, also called “payroll taxes,” also called “FICA” taxes. These amount to 7.65% (combined) for you the employee and another 7.65% for the employer. If you work for yourself you’re both the employee and employer, meaning you pay both (15.3%). 6.2 of that 7.65 is capped. For 2018, it goes away after $127k of income (per person). This tax can be more than the income tax, as is the case for our example family of 4. It gets less attention because it’s just a flat rate and doesn’t come along with deductions and maneuvers to minimize it.

Go flip that envelop over

This quick, rough, federal income tax calculation is, dare I say, pretty basic? Income minus 2 types of reductions, times tax rates, minus credits. It can get much more complicated, but, now you can back of the envelope it with confidence and be more one with your money.