Editors’ note: I’m excited to introduce Krista D’Innocenzo as a guest poster. Krista is a mechanical engineer graduated from the Colorado School of Mines. To kick off 2017, Krista gives an introduction to Federal Income Taxes and addresses the persistent myth that you should take a lower salary to avoid taxes.
When I saw that Will was working on a personal finance blog, I figured I’d follow along, since personal finance is a passion of mine. As someone who has been all over the financial “spectrum,” I reached out to Will because I want to share my experiences and findings (and especially mistakes) so that others can learn. I am by no means an expert and obviously I don’t know all the answers. I’m merely someone who gets depressed seeing all the articles claiming “1% of millennials have more than $10 in their bank accounts!!” and wants to do something about it.
Why do I care?
When I first started looking at information about personal finance, I was bombarded with books and articles where the first paragraph had acronyms like 401k, Roth IRA, VSTMX, and ETF and my eyes would just glaze over. I had no idea what any of those words were and all the information I found seemed to assume I already had a working knowledge of personal finance. My goal as a guest contributor is to explain what I know about personal finance in basic terms that anyone can understand.
Learning to control your finances is powerful because it will take you to a place where you are truly in charge of your life, rather than a credit card company or the bank that owns your student loans. The reality is that most of our generation was never taught personal finance and has graduated with student loan debt; it can feel pretty depressing to be in a hole that you see no way to climb out of. Some have graduated with little debt and a high paying job, but have no idea what to do with the money. Some may be saving up to buy a house or have a child but feel that dream is unreachable. My goal is to be able to share the information I’ve learned from being in these situations so that others don’t have to go through the struggle that I did to find it.
My Financial Goals
I approach my personal finances with the goal of financial independence, living a lifestyle independent of income. My goal is to eventually retire early and live off of passive investments within the next 16 years. While this lifestyle isn’t for everyone, it’s more easily attainable than you might think. While I do my best to live somewhat frugally, I am by no means a spendthrift and still enjoy traveling, eating out, and buying tech gadgets. I hope to be able to offer information to others who want to retire early as well as those who don’t.
Introduction to Income Taxes
When I first looked at my first paycheck as a teenager, it shocked me to see the government take so much of my money, the horror! With time, I’ve grown to enjoy seeing my sweet, sweet tax refund check arriving each year in April. Who knew I’d be so excited about providing an interest free loan to the federal government?! Let’s start with all the different types of taxes you’d typically see on your paycheck:
Federal Income Taxes
When most people curse the IRS, it’s in reference to their federal income taxes, taxes paid to the federal government deducted from your earned income (salary, Social Security benefits, investment income, etc. ). The U.S. follows a progressive tax system, meaning that as income increases so does the rate of taxation. This leads to different tax rates ranging from 10% of the first $9,275 earned to 39.6% of income earned over $415,050 per year. Bands of income receiving the same tax rate are known as “brackets,” and 2016 tax brackets are as follows:
|Rate||Single Filers||Married Joint Filers||Head of Household Filers|
|10%||$0 to $9,275||$0 to $18,550||$0 to $13,250|
|15%||$9,275 to $37,650||$18,550 to $75,300||$13,250 to $50,400|
|25%||$37,650 to $91,150||$75,300 to $151,900||$50,400 to $130,150|
|28%||$91,150 to $190,150||$151,900 to $231,450||$130,150 to $210,800|
|33%||$190,150 to $413,350||$231,450 to $413,350||$210,800 to $413,350|
|35%||$413,350 to $415,050||$413,350 to $466,950||$413,350 to $441,000|
The Tax Bracket Myth
Have you ever heard someone complain about a promotion or raise because making more money would put them in a higher tax bracket, causing them to take home less money than they did before? This is a myth caused by people mistakenly assuming that their highest income tax rate will apply to all of their income. This is false and easy to debunk if you look at how these tax rates work. Let’s say you are a single person who made $35,000 this year. Your federal income tax you would be 10% on the first $9,275 earned plus 15% of the amount earned between $9,275 and $37,650. The math looks like this:
So at the end of the year, you have paid $4,786.25 in tax, which leaves $30,213.75 leftover. Now let’s assume you get a raise and now make $38,000, putting you just over the threshold into the 25% bracket. Now you pay:
So you pay $5,271.25 in taxes, leaving you with $32,728.75. You do pay more in taxes, as one would assume with a higher income, but at the end of the day you still take home more income. Remember, bumping up into the 25% tax bracket does not mean that your entire income is taxed at 25%, just the portion of your income above the lower tax brackets is taxed at that amount. More money gross always leads to more money net!
Your Status Is Not Complicated
What’s the difference between single, married filing jointly, and head of household? Single filers are people not married on December 31 of the tax year with no dependents. Married filers are people who are legally married on December 31 of the tax year. Notice that the IRS does not care if you were married until December 30th and divorced on December 31st, you will still have to file as single for the year.
Your Roommate is Not a Qualifying Dependent
Head of household filers are people who have dependents that live with them who they are not married to. The word “dependent” is the IRS definition of a dependent, which can be found here. In short, a dependent is a child or relative for who relies on you as their primary source of financial support. For example, divorced parents cannot both claim the same child as a dependent. Full criteria for filing head of household can be found here.
Income thresholds are higher for the married and head of household filers, because they are assumed to support more than one person. For married couples where one spouse makes much more than the other, this often manifests as paying less in taxes than if each person were to file as single. For married couples where both spouses have high incomes or both make very little, this often manifests as paying more in taxes than if each person were to file as single. To see if you and your spouse are getting a “marriage bonus” or a “marriage penalty,” check out the interactive chart here (using 2015 tax numbers).
State Income Taxes
Different states have different income tax percentages, and some do not take income tax at all. If you live in one state and work in another, or have income from another state, you will need to file tax returns in every state you have earned income (and possibly more). For more information, review this article from Intuit.
Social Security and Medicare tax
Social Security and Medicare taxes are withheld from your paycheck at 6.2% and 1.45% respectively, and only the first $118,500 (Social Security) and $200,000 (Medicare) earned each year are subject to these taxes for the 2016 tax year. It is important to note that the income limit for Social Security tax is being increased in 2017 to $127,200.
What does it mean to have tax withheld and how do you know if you will get a refund or have to pay taxes in April? The federal government knows that it can’t just take money for taxes as a lump sum once per year, because a vast majority of people would not have funds available. Therefore, taxes are withheld by your employer on each paycheck at a rate that is dependent on your income, your pay schedule, and how many deductions you’ve claimed with your payroll department. Think of withholdings as an estimation of roughly how much tax you should pay. At tax time, the amount that was withheld (what you DID pay in taxes) is compared to the actual amount required and you will either have to pay more or you get some money back.
A refund means that you provided a short-term interest free loan to the federal government, but this may be the easiest way to handle your taxes if you do not want to take the time to figure out all of your deductions beforehand or don’t want to take the risk of estimating incorrectly. Deductions can be fairly complicated and are another blog post to themselves, and obviously I am not a tax professional and your personal situation may vary. Consult with a CPA for specific advice on your own taxes.