In the US, there are four taxes you will see most: Income Tax, Capital Gains Tax, Sales Tax, and Property Taxes. There are other taxes out there, but when people think of paying taxes, these are the big four. Property and Sales taxes are usually at the local or state level. Each state, county, or even city, can have its own local taxes. The only way to lower your local taxes in most cases is to buy less. Income and Capital Gains taxes are paid both on the federal and state level (unless your state has no income tax).
Income taxes are relatively simple in concept. If you are a US citizen, you must pay US income taxes on your WORLDWIDE income. The bottom line is, you owe taxes on whatever you make. This includes income from your regular employment (W-2 income), side gig or small business (1099 income), and any other income. If you hear the terms W-2 or 1099, that has to do with which IRS form it is reported on.
When you work for an employer, they take taxes out of your paycheck each check to pay for income taxes. A W-2 is just a record of what they have taken out of your check and paid to your local, state, and federal taxes. They also take out for Social Security and Medicare. If your company is taking out too much, you will get a refund (or the opposite if they take out too little). Your company plans what to take out based upon what you told them on a W-4 (withholding instructions). If your life has changed (such as from single to married, or different state), make sure you update your W-4 with your company.
If you have 1099 income, that effectively means you are your own small business. That means you need to both keep track of your expenses, and make quarterly estimated tax payments. For simple math, if you make $10,000 in 1099 income, and have $5,000 in expenses, you have to pay income taxes on the other $5,000. Additionally, since you are self-employed for the 1099 income, you need to pay self-employment taxes, which covers what an employer pays for social security and medicare. Both the IRS and your state (if they have income taxes) require you to pay quarterly estimates of these taxes. It isn’t exactly every three months, so look at this chart. Bottom line is that if you don’t pay in on your 1099 income over the year, you will have a large tax bill due and may have to pay penalties and fees. While the IRS does not give us interest on anything we overpay, they can (and do) charge us for an underpayment.
If you just have one W-2 income, in one state, your taxes are relatively simple. You should be able to file your taxes through a free service like https://freetaxusa.com or others. Make sure you do not pay for extra services if you don’t need them. It is popular now for services to offer to give you your refund early. What this really means is they are loaning you your refund, with associated fees added on. Be patient.
A simple tax return looks like this: (in 2022, example for illustrative purposes only)
I made $50,000 last year.
I am single so the standard deduction is $12,950.
That means I will pay Federal income taxes on $37,050.
The US uses a series of tax brackets, so I would pay 10% of the first $10,275 ($1,027.50) and 12% of the next $26,775 ($3,213). The total Federal Income tax bill would be $4,240.50, an effective income tax rate of 8.48%.
This is a very simplistic example and does not take into account Social Security, Medicare, and state/local taxes, but it is here just to help you understand how it works.
There are two things that confuse people with income taxes: Deductions and Tax Brackets.
How you file your taxes determines both your standard deduction and tax brackets. The four filing statuses are: Single, Married Filing Jointly, Married Filing Separately, and Head of Household. Simply, if you are Single you file Single unless you have a dependent, and then you may have an option to file Head of Household. Childfree people would rarely file Head of Household unless they had another family member living with them, who is dependent on them and they can claim on their taxes (think an elderly or special needs family member). Most married couples are going to file jointly unless there is a specific reason to file separately. Reasons to file separately include having to qualify for a specific program or incentive (such as for government assistance) or some odd cases with disparities in income. Luckily, most tax software will run your returns both ways and tell you which way to file.
It used to be common to have to itemize your tax deductions. Itemizing tax deductions included a giant box of receipts and accounting for every penny you spent in different categories. In 2017, the Tax Cut and Jobs Act (TCJA) doubled the standard deduction, and the result is that an estimated 90% of people take the standard deduction ($12,950 for single, $25,900 for married filing jointly). At the same time, there was a limit put on State and Local Taxes (SALT) of $10,000, so for most people, it is very hard to itemize more deductions than the standard deduction. It also means that writing off mortgage interest is no longer as attractive, but it does make your taxes much simpler. There are some additional deductions for being over 65 or blind.
In the US we have a marginal tax rate system ranging from 10-37%. The thing to keep in mind is that while you go up in income the marginal rate goes up, but only applies to additional income over a certain amount. For example, if you are filing Married Filing Jointly, and have $100k in income, the first $20,550 is taxed at 10%, the amounts between 20,500 and 83,500 are taxed at 12%, and the amounts between $83,550 and $100,00 would be taxed at 22%. This can be confusing, but the effect is that the actual tax rate you pay on your income is lower than your top marginal rate.
I hear people all the time say that working overtime isn’t worth it because it ‘bumps you into another tax bracket’. The truth is, it doesn’t. You may feel like there is a lot taken out of your check when you get a bonus or overtime, and that is because the payroll system assumes you are making more for the entire year. When you file your taxes you will take out the standard deduction, and then pay the appropriate percentage in each range. If your bonus or overtime bumps you into a new marginal rate, you are only paying the higher tax rate on the part that falls over the edge.
Capital Gains Tax
In addition to your income tax, you will pay a lower rate on all long-term capital gains. Long-term capital gains rates are paid on investments and other items held for over a year, and are at either 0%, 15%, or 20%, depending on your income (most people are in the 15% range). There are some special cases with different rates (such as collectibles) and there are special rules for selling your primary home, but the bottom line is that long-term capital gains normally saves you money. To qualify for long-term capital gains, you have to wait 1 year and 1 day after you buy something to sell it. Your capital gains can be offset by capital losses, and a capital loss may offset your income taxes (up to a $3,000 limit, which can be carried over).
A note of caution: There are specific rules for investing that can disallow losses on stocks. If you sell a stock at a loss and then buy the same stock (or similar) within 30 days, it can cause a ‘Wash Sale’. A Wash Sale is the IRS’s way of saying that you don’t get to record the loss, it is ‘disallowed’. There have been many cases of people who thought it was fun to day trade through apps who got bit by the Wash Sale rules. The result for many has been hundreds of thousands of dollars in IRS bills. Don’t day trade, and watch out for Wash Sales.
Using Tax-Advantaged Accounts to Lower Your Tax Burden
While you have to pay taxes on all of your income and earnings, it is possible to use some special accounts to choose when you pay your taxes and to potentially save on taxes.
Health Savings Accounts (HSAs) – If you have a high deductible healthcare plan, you may have access to an HSA account. An HSA account is a rare ‘triple tax benefit’ account, where you get a deduction for putting your money into an HSA, it can then be invested and it grows tax-free, and then if used for medical benefits, there are no taxes when you take it out. An HSA is a great tool to plan for long-term medical expenses and long-term care. If you have access to one, you may want to max it out each year. Keep in mind that it may not be worth changing your healthcare plan to get an HSA account, as you often have to sacrifice healthcare benefits in return.
Traditional IRA/401(k)/403(b) (pre-tax) – A Traditional 401(k) allows you to put in money ‘pre-tax’ now, which means you get to lower your income tax now. The money then grows via investments and you have to pay income taxes when you take it out in retirement. Keep in mind that you have to be 59 ½ to take your money out without a 10% penalty (or meet other requirements). The other thing to keep in mind is that Traditional accounts have Required Minimum Distributions (RMDs) that you will have to take out after you reach 72. RMDs can force you into a much higher tax bracket in your retirement, so do the math.
Roth IRA/401(k)/403(b) (post-tax) – For a Roth 401(k), you pay the income tax now, but it grows tax-free and you can take it out tax-free after you reach 59 ½ (or meet other requirements, otherwise there is the same 10% penalty). A Roth account does not have RMDs. I personally leverage Roth accounts first, as I like the idea of the money all being mine in the end. For my clients, I encourage Roth contributions unless they have a specific reason they need to lower their income with a Traditional.
There are limits to how much you can put into each IRA and 401(k)/403(b) account. For IRAs, these limits shift based upon your income.
The bottom line is that you need to have a good understanding of tax planning in order to limit the amount of taxes you pay, and to control the timing of when you pay taxes. There are times when paying taxes now can save you in the future (such as the Roth). There are also times when you can get a bigger refund now. If you run a small business (or have other 1099 income) there are opportunities to save taxes by good expense record keeping and starting your own Solo 401(k) or similar, but that is a whole topic on its own. Also, if your company offers stock options (ISOs/RSUs/etc), the tax rules get even more complex.
If you have a simple tax return (one W-2 and one state), you can most likely use free tax software. As your taxes and investing get more complex, you will want some help. CPAs (Certified Public Accountants) and EAs (Enrolled Agents) are experts in tax filling. For tax planning, you will want to reach out to an Advice-Only, Fee-Only, Fiduciary, CERTIFIED FINANCIAL PLANNER®. Make sure the CFP® professional you work with understands that being Childfree may change your tax and investing plan. If you would like someone to bounce ideas off of, we offer a no-cost 60 minute introduction meeting at https://calendly.com/coachdrjay/childfree and you can learn more about us at https://childfreewealth.com