U.S. Tax System 101
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If you’re one of the many people who have no clue on how the U.S. tax system works, this is the post for you. This post will go over some of the major taxes U.S. workers pay, the important tax lingo (e.g. tax brackets, deductions, marginal & effective tax rates, etc.), and of course go over some walk through examples. I’ll go over important topics related to actually filing taxes in another post that will hopefully be out soon.
The Big Four Income Taxes
In the U.S., the majority of workers have to pay the Big Four Taxes: federal, state, and FICA taxes (which are Social Security and Medicare taxes). The federal, and most state governments, have a progressive tax system (more on that later). FICA taxes on the other hand are flat taxes, so no matter how much money you make, 7.65% of your income will be taxed for FICA taxes(more on FICA taxes here). The Internal Revenue Service, or the IRS, takes the federal and FICA taxes while the state taxes are taken by your state’s own tax department. Currently, those who live in Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming don’t have to worry about state taxes. Some cities like New York, New York however, not only have to pay the Big Four Taxes but also an additional local city tax.
The Progressive Tax System
In the U.S. we have a multi tiered, progressive tax system. This means that your total income is not taxed at a single tax rate. Instead, brackets of your income are taxed at different rates depending on factors such as your filing status (e.g married or single) and income level. Generally, the higher your income, the higher the taxes. This is easier to comprehend with an example, but before we get into an example, let’s go through some of the lingo.
Filing Status: This is mainly based on marital status and family situation. There are 5 filing statuses: single, married filing jointly, married filing separately, head of household, and qualifying widower. If you’re a single child you would most likely be considered a dependent. You can use this IRS tool to figure out your filing status.
Tax Brackets: These are the ranges of income that have corresponding different tax rates. As of 2020, there are 7 different tax brackets that are dependent on your filing status and are taxed at rates between 10% – 37% depending on the tax bracket. **This is the reason why you should never be worried about accepting a raise, because even if you’re pushed to a higher tax bracket after the raise, only that extra income will be taxed at a potentially higher tax rate. Bottom line, you will always make more money with a raise!** See below for the 2019 & 2020 tax brackets by filing status.
**Qualifying Widowers have the same tax brackets as Married, filing jointly**
Marginal Tax rate: This is the highest rate that your income is taxed at. It does NOT equate to your actual tax rate! For example, say you’re a Single filer who made an income of $80,000 in 2019. You would fall into the third tax bracket because your income is between $39,476 and $84,200. And according to the IRS your marginal tax rate is 22%. However, this does NOT mean that you pay a 22% tax rate on your entire income, only on the income made above $39,475 (see tax bracket image above). In other words, you only pay that 22% tax rate on $40,525 of your income ($80,000 – $39,475). The rest of your income will be taxed at lower rates (look at the pic y’all).
Effective Tax Rate: This is the average tax rate you pay on your income. As stated in the previous example, only $40,525 of your $80,000 is taxed at 22%. Your income between $9,701 – $39,475 is taxed at 12% and the income between $0-$9,700 is only taxed at 10%. The math shakes out to an effective federal tax rate of only 13.47% even though your marginal tax is 22%. You can use this calculator to see what the effective tax rate would be for different incomes in different states. **Again, the effective tax rate is the actual tax rate you pay the IRS while the marginal tax rate is just the highest tax rate you pay on part of your income.**
Tax Tables: While taxes owed is essentially calculated as I explained in the effective tax rate section, in practice, the calculation is slightly different. Every year, the IRS and individual state governments release tax tables which show the exact amount of taxes due depending on your taxable income and filing status. However, the taxable income groups are in ranges of $50. So, if you’re a Single filer with a taxable income of $80,000, you would look for the taxable income range of $80,000 – $80,050 and the corresponding taxes owed under Single filer. Those with taxable income of at least $80,000 but less than $80,050 all owe the same amount of taxes, even though there’s a small taxable income difference. In Tax example 1, I’ll use the slightly off calculator method to better illustrate the the progressive U.S. tax system but use the tax tables to show you the right answer. In practice, you don’t have to worry about the calculation because tax softwares auto calculate for you based off your inputs, but if you’re a weirdo who likes to manually do your tax forms you’ll definitely need to refer to the tax tables!
NOTE: If you were one of the people who actually did the math in the effective tax rate section and/or looked up the taxes owed in the tax table for a Single filer with a taxable income of $80,000 you might’ve noticed that the taxes owed is off. Nice! You’re right, the taxes owed in the effective tax rate section versus the tax tables are thousands of dollars different! Why? Well because, the calculator automatically accounted for the standard deduction while the tax tables assume that you’re using taxable income that’s already deducted the standard or itemized deductions. Don’t worry, we go over deductions in the next sections!
Types of Deductions
There are several deductions you can take to lower your taxable income. Remember, the lower your taxable income, the less taxes you pay. I’ll go through some examples of deductions below. At minimum, you can choose between a standard deduction or itemized deductions.
Standard deduction: Nearly everyone qualifies for the standard deduction, which is a flat income deduction that’s dependent on your filing status. In the previous example, since you’re a Single filer, you’d qualify for a $12,200 standard deduction (see below for the 2019 & 2020 standard deduction table). This amount you can keep, without having it taxed by the IRS. Even though you made $80,000, the IRS taxes you like you’ve only made $67,800 ($80,000 – $12,200). **Remember, the standard deduction is a fixed amount based on your filing status. Whether you made $20,000 or $1,000,000, if you’re a single filer the most you qualify for is a standard deduction of $12,200.** Typically it’s better for most Americans to take the standard deduction, but if you own a home, had expensive medical bills, or give a lot to charity, itemizing deductions may be a better option. Also there are a few cases where you have to itemize deductions – you were a non-resident alien for any part of the tax year, you’re married, filing separately and your spouse is itemizing, and you’re filing for less than a 12 month period because of a change in your yearly tax accounting. Also, please keep in mind the below chart is only for Federal taxes, states can have their own standard deduction (e.g. California’s standard deductions are much lower than the federal one).
Itemizing Deductions: Instead of taking the standard deduction you can choose to itemize deductions you qualify for. Itemized deductions include: State or local taxes, property taxes, primary home mortgage interest, qualified, unreimbursed medical & dental expenses that were greater than 7.5% of your gross income, qualified gifts to charity, and casualty and theft loss(es) from a federally declared disaster. These take more effort to calculate than a standard deduction (because you don’t have to calculate at all for the standard deduction) but can potentially save you more $. The form you’d use to itemize deductions is Schedule A. **Go through Schedule A and add up all the itemized deductions you qualify for, if the sum of the total is greater than the standard deduction, opt for itemizing your deductions.Note, the maximum state/local taxes & real estate taxes you can deduct is the lower of the taxed paid or $10,000.**
Other Deductions: On top of choosing either the standard or itemized deductions, there are a ton of other deductions you can take advantage of if you qualify for them such as: Traditional IRA contributions (IRA post), Traditional 401k contributions (should be automatically deducted from your wage & W2 – 401k post), student loan interest deduction, HSA contributions, etc.
Tax Credits
Tax Credits: These are actually way better than deductions because if you qualify for tax credits they reduce your taxes DIRECTLY, dollar-for-dollar. Examples of tax credits include: the earned income tax credit, child tax credit, education tax credits, savers credit, etc. Let’s go through a simple example. If you were a Single filer who made $80,000 in 2019, then you would owe $10,775 in federal income tax (if you just used the standard deduction). **Remember, you can use this tax calculator to see what you’d owe.** However, if you qualify for a tax credit of $1,000, your taxes would drop by $1,000 to $9,775, because tax credits reduce taxes owed dollar-for-dollar. If you only qualified for a $1,000 tax deduction instead of a tax credit, your taxes would only be reduced by $220 to $10,555. This is because simply reducing your income by $1,000 means that you’re only saving money on the taxes you would’ve paid on that $1,000. Remember, your marginal rate is 22% and $1,000 * 22% = $220.
Sorry I didn’t realize how much I needed to explain! Anyways, on to a visual example!
Examples
Example 1: You're a Single Filer who made $80,000 in 2019
Additional information: You’re a renter with no loans, no children, gave nothing to charity, and had no large medical bills. You also live In California. See the below cartoon, made by Julie Lim, to see how the Federal tax system works!
Recap of the above example:
- Standard Deduction for Single Filer: $12,200
- Itemized Deductions: $4,190 (California State Taxes)
- Best Deduction: Standard > Itemized Deductions
- Taxable income: $80,000 – $12,200 = $67,800
- Marginal Tax Rate: 22%
- Effective Tax Rate: 13.47%
- Total Federal Taxes Due: $10,780 (using the 2019 Federal Tax Tables)
- The slightly off manual calculation: $10,774.50. See the Tax tables section for more information.
Example 2: You and your spouse jointly make $80,000 and file as Married, filing jointly in 2019
Additional Information: You both are still renting, have no kids, donated $2,000 to a qualified charity, and had no major medical bills. You both live in California.
- Standard Deduction for Married, Filing Jointly: $24,400
- Itemized Deductions: $3,924 ($2,000 from the charity + $1,924 from CA State Taxes)
- Best Deduction: Standard Deduction > Itemized Deductions
- Taxable Income: $80,000 – $24,400 = $55,600
- Marginal Tax Rate: 12%
- Effective Tax Rate: 7.86%
- Total Federal Taxes Due: $6,284
- Note: The married couple pays $4,496 less in taxes than the single you making the same amount because of that more generous tax bracket.
Example 3: The 2019 Single Filer pushed over to the next tax bracket
Additional Information: You’re a renter with no loans, no kids, no large medical bills, and no large charitable contributions. You live in California. Let’s go through examples of 2 different income scenarios.
Scenario 1: 2019 Income is $50,000
- Standard Deduction for Single Filer: $12,200
- Itemized Deductions: $1,563 (CA State Taxes)
- Best Deduction: Standard Deduction > Itemized Deductions
- Taxable Income: $50,000 – 12,200 = $37,800
- Marginal Tax Rate: 12%
- Effective Tax Rate: 8.68%
- Total Federal Taxes Due: $4,342
Scenario 2: 2019 Income is $55,000
- Standard Deduction for Single Filer: $12,200
- Itemized Deductions: $1,957 (CA State Taxes)
- Best Deduction: Standard Deduction > Itemized Deductions
- Taxable Income: $55,000 – $12,200 = $42,800
- Marginal Tax Rate: 22%
- Effective Tax Rate: 9.59%
- Total Federal Taxes Due: $5,274.50
Scenario 1: 2019 Income is $50,000
Scenario 2: 2019 Income is $55,000
- Standard Deduction for Single Filer: $12,200
- Itemized Deductions: $1,565 (CA State Taxes)
- Best Deduction: Standard Deduction > Itemized Deductions
- Taxable Income: $50,000 – 12,200 = $37,800
- Marginal Tax Rate: 12%
- Effective Tax Rate: 8.68%
- Total Federal Taxes Due: $4,342
- Standard Deduction for Single Filer: $12,200
- Itemized Deductions: $1,960 (CA State Taxes)
- Best Deduction: Standard Deduction > Itemized Deductions
- Taxable Income: $55,000 – $12,200 = $42,800
- Marginal Tax Rate: 22%
- Effective Tax Rate: 9.59%
- Total Federal Taxes Due: $5,274.50
Takeaway: After getting that $5,000/10% raise your marginal tax rate also increases by 10% from 12% to 22%. However, your effective tax rate increased by less than 1%! This is because only the income pushed into that new 22% income bracket is taxed at the higher 22% tax rate. If you look at the 2019 Tax bracket table you’ll see that only income between $39,476 and $84,200 is taxed at 22%. So, of that $5,000 raise, $3,325 would be taxed at 22% ($42,800 (taxable income) – $39,475 (12% tax bracket limit)) and the remaining $1,675 ($5,000 – $3,325) would be taxed at 12% to close out that 12% tax bracket. Due to that $5,000 raise, you would have to pay an additional tax of $932.50 ($3,325 * 22% + $1,675 * 12%). Bottomline, don’t be afraid to take that raise! Sure you’ll pay more taxes overall (more money, more taxes) but you will have a higher net income overall.
Example 4: The 2019 Single filer with itemized deductions & retirement contributions
Additional Information:
- Income: $100,000
- California State Taxes: $3,353 (Calculator)
- Traditional 401K Contributions: $12,000
- Mortgage Interest Paid: $14,000
- Property Taxes Paid: $3,500
- Qualified Charitable Contributions: $4,000
Breakdown of Example 4:
- Traditional 401K Contributions: $12,000
- Remember, traditional 401k contributions directly reduce your taxable income
- Standard Deduction for Single Filer: $12,200
- Itemized Deductions:
- Total Deductible Taxes: $6,853 (Lower of $10,000 and $9,546 ($3,353 (CA taxes) + $3,500 (Property Taxes)))
- Mortgage Interest Paid: $14,000
- Qualified Charitable Contributions: $4,000
- Total Itemized Deductions: $24,853 ($6,853 + $14,000 + $4,000)
- Best Deduction: Standard Deduction < Itemized Deductions
- Taxable Income: $100,000 – $12,000 (401K) – $24,853 (Itemized deductions) = $63,147
- Marginal Tax Rate: 22%
- Effective Tax Rate: 9.15%
- Total Federal Taxes Due: $9,146
TLDR: The Big Takeaways
Cmon people, this post is relatively short compared to others! Just read the whole thing. Anyways, the big take aways are the following:
- The U.S. has a progressive tax system. The more you make the more you get taxed. It’s like a scale, where brackets of your income are taxed at different rates.
- Tax brackets are based off of your filing status which is based off your martial and family situation.
- The marginal tax rate is the highest tax rate you’re taxed and the effective tax rate is the actual tax rate you pay.
- You’re not taxed on the full income you make. There are a number of deductions you can take, most popular is the standard deduction, to lower your taxable income.
- If you can, you should take advantage of opportunities to legally lower your taxable income. Popular methods include: contributing to your 401k, traditional IRA, HSA, and itemizing deductions when it’s greater than your standard deduction.
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