Help me understand the basics of income taxes!

“In this world, nothing can be said to be certain other than death and taxes“

Benjamin Franklin

We all know about taxes and most of us including myself a few years ago would groan when we hear the word ‘taxes’ – BORING!! I could not have thought of anything more boring to talk about so it’s quite unbelievable to me in some ways that I am actually writing (and will continue to write) about income taxes. But understanding income taxes is probably one of the most important pieces of financial literacy. This article is going to be a basic 101 article meant for folks to get the basics. I want to write about more tax planning techniques but I felt it was important to get all my readers this 101 article before I do that. So I will write in future about some more advanced topics around taxes. But I will make a disclaimer now I normally make at the end of all my articles. I am not a CPA or a tax planner. So this is purely educational. You will need to consult with your CPA to do any tax planning or tax moves. One more thing – this article is pretty US centric so if you are not paying taxes in the US, this article will most likely not be useful. If you live in a part of the world where you don’t pay income taxes, then you definitely don’t need to bother with this article! 🙂

What are income taxes?

I will keep this simple. The government exists to provide services to its citizens ranging from national defense, law enforcement, maintaining social programs, community development and so on. In order to pay for all this, the government collects taxes from its citizens. There are different types of taxes and one of the biggest kinds of taxes is Income taxes. Taxes are the biggest source of revenue for the government. No need to further complicate this. 

How are income taxes calculated? 

Before we go into too much detail, let’s stay at a high level and understand a simple equation to calculate your income taxes. We will then go over each of these in a bit more detail:

If you are lookin at the above equation and telling me, “you call this simple? There is nothing intuitive about the above equation!” I hear you. Well, trust me when I tell you the above equation is the simplest I can explain it. This is the dummies’ high level version of the dreaded Form 1040 that shows your actual tax returns! The good news is that if you understand the above, this is good enough to have a good overview of your income taxes. So let’s dig a bit into each of the above line items.  

1. Gross Income 

Gross income is simply the sum total of all the income you earned in a year that the IRS (Internal Revenue Service – USA) says is taxable. This includes:

• Wages / Earnings through working a job or self-employment or tips etc
• Interest income
• Dividend income
• Rental Income
• Income from capital gains
• Any other form of income

This is where most of the tax planning occurs especially if you are someone who can shift your income from sources other than W2 income. I will talk about this in more detail in a future article.

2 and 3. Adjusted Gross Income (AGI) and deductions

This is an important part of taxes you need to know because for most average people (especially if you are a regular W2 income earner), this is where the most common tax planning occurs. So let’s start by defining this. Adjusted Gross Income (AGI) is simply your Gross Income – specific deductions/adjustments. For taxation purposes, all your tax calculations are done on your AGI. So by keeping your AGI as low as possible, you benefit by paying lower taxes. AGI is also used by the government to calculate who is eligible for a lot of government programs, subsidies, stimulus payments and so on. These adjustments are called ‘above-the-line’ adjustments. So what are these adjustments?

• Essentially there are a bunch of adjustments but the most popular one is a contribution to tax deferred IRAs/401Ks. Remember, those pesky deductions that happen from your monthly paycheck that makes you feel poor? Well this is where they show their immediate benefit. They reduce your gross income in the year you made the contribution. There are limits to how much you can contribute each year. Remember, the intent is that Uncle Sam will collect taxes on these when you do withdraw them at retirement. 
• The other popular deduction that has caught on recently is the Health Savings Accounts (HSA) contributions. If you use these for healthcare expenses, you never have to pay taxes on these!
• There are other deductions as well – all of which can be viewed in this link under PART II (Adjustments to Income): https://www.irs.gov/pub/irs-pdf/f1040s1.pdf from the IRS. 

4 and 5. Standard deduction, Itemized deductions and Taxable Income

The government decided that everyone needs to set aside some basic expenses that should not be taxed and they decided to offer that in the form of standard deductions or itemized deductions. Essentially, you get to deduct this from your AGI to calculate your taxable income. These adjustments are called ‘below-the-line’ adjustments. 

You can either choose to take a flat amount which is the standard deduction or choose to itemize certain deductions. You cannot do both. So you or your CPA will typically calculate each year which of these deductions reduces your taxable income more and accordingly use that. The 2017 Tax cuts and Jobs act made it more attractive for the majority of the folks to take the standard deduction through the capping of certain deductions. I promised to keep this simple so I am not going to go into the types of itemized deductions. If you are really keen on knowing the itemized deductions then visit the IRS link: https://www.irs.gov/pub/irs-pdf/f1040sa.pdf to enter all your itemized deductions and calculate the total. Below are the standard deductions for 2021 depending on your filing status:

6. Tax rates:

Finally, you may be familiar with the famous tax brackets. In the world of income taxes in the US, at a high level, we have Federal and State Income taxes (41 out of the 50 US states as writing this article have state income taxes). We won’t go into details of state taxes because that varies so much by state. US income taxes are a progressive tax system. That simply means people who earn more income pay more for the income earned above certain amounts. Below are the 2021 US Federal Income Taxes depending on your status. You calculate the taxes payable by multiplying the below rates on your taxable income. 

What is important to note is when someone says they are in the 35% tax bracket and they are paying 35% on only the income above the threshold, not on all of their income. This is a common misconception. 

Lets bring this all together with an example

We have a married couple who have decided to file jointly and earn a combined gross income of $150,000 and each contribute $10,000 into their 401K (total of $20,000) and another $5000 in their HSAs. They have decided to use the standard deduction. They live in a state with no local income tax so this is their federal tax return.

Final concluding thoughts

If you are still reading this article, by now you should have realized some different ways by which you could reduce your taxes. If the above couple had chosen NOT to put away money in a 401K or an HSA, their taxable income would have gone up by $25,000 and made them pay an additional $5588 in taxes! This is an overly simple example but still conveys the fundamental essence of basic tax planning. There is obviously a lot more thinking that needs to go behind this. For legal tax planning, you need to figure out how you can reduce your taxable income in any given year and there are different ways to do it. You have to get familiar with the different tax planning tools. I will go into some detail in some of that in future articles

For today, I will conclude with this. My hope was to help simplify (somewhat) what is considered a painful and boring part of our financial life. While I was always satisfied to simply hand over doing my taxes to a CPA, I came to realize that if I need to optimize (and simplify) my finances, understanding the tax component is very critical. 

Thank you for reading and I wish you success in your financial journey.

Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice.