Understand Taxes in 10 Minutes!

Understand Taxes in 10 MinutesPeople speak of calculating their taxes like it's some sort complex algorithm, only understood by the great financial sages of our time.  Others believe that no one really knows what you should be paying, that it's all just random and all you can do is hope you get it close enough to avoid a tax audit!  Maybe this misconception is caused from the misinformed belief that money matters are difficult, private, and shouldn't be discussed (let alone understood!), but these beliefs are dumbfounding to someone who knows the rules and just how simple they really are!  The real truth is that, for most people, determining your personal taxes is so easy that anyone with a middle school education can do it!

Knowing how simple it really is, I'm always baffled when I talk to intelligent, active thinkers who view taxes as a mystery because that's all they've been told.  So today I'd like to take the mystery out of it!  I'll break down the concepts surrounding taxes as simply as possible so that you can understand taxes in 10 minutes and then be able to calculate your own taxes so that you can be confident that you're paying the right amount AND so that you can plan appropriately for tax years to come!

 

Taxes for the Employed

Assuming you work for an employer, you get a weekly/bi-weekly/monthly paycheck.  But, as I'm sure you've noticed, out of that check you don't see all of your pay (I know that after receiving my first paycheck I was disheartened, seeing how much was lost to taxes!)  Out of the cut disappearing, there are two categories - social service taxes and a defined amount of withholding (which is used to pay the other half of your taxes later down the line).

Regardless of your level of compensation, 6.2% of each check will disappear to Social Security and an additional 1.45% to Medicare.  (The self-employed are actually required to pay twice this rate because they don't have an employer legally required to pay the other half of your Social Security/Medicare taxes!)  The remaining 92.35% is considered taxable income.  This is the figure you will use to see what you will use with federal and state taxes.

 

Aside from your Social Security/Medicare costs, there are an additional two types of taxes that will be taken from your taxable income (that 92.35%)you have left) - federal and state taxes.  Your state tax rate will vary depending on where you live, but the federal tax rate will apply equally to everyone in the US.  (Federal taxes are also what people often mistakenly use to identify what your 'tax rate' is.  People claim that if you make x-amount you are taxed at y-percent - this is not correct.)

Federal taxes work in brackets.  The more you make, the higher percentage of your earnings go to taxes for each dollar OVER a predefined earning limit.  Let me repeat myself - the higher rate that you pay is determined by how much you make OVER a certain cut off point!  Again, state taxes are different for everyone so my circumstances could be different from yours, but in my state (South Carolina), we also work on a bracket system which levels out at 7%.

(At the bottom of this article, I'm including two tables which I'm referring to when talking about my federal and state tax rates.  Please refer to them to see how the numbers align, as well as how your numbers will align.  If you want to skip to the bottom of the article, then back here, that might be beneficial, as well.)

Maybe those tables just hopefully just glanced at seemed a bit daunting.  They really aren't.  To use an example us to show how simple they actually are to utilize.  Before we cover the example, though, we need to talk about deductions.

A tax deduction is an amount of income that, simply, is not taxed.  When referring to the tax tables, this amount of money is taken "from the top" - meaning that it avoids taxes in the highest relating bracket.  If you're claiming yourself as independent, then you have (at the minimum) a standard deduction of $10,400 (as of 2015 tax laws).  If you have dependent children or are married (or have a significant amount of interest on loans that you are paying), you may be able to claim a higher deduction than this.  For the sake of this article, though, we will just run through the case of a single independent claiming the standard deduction.  If you have a specific question outside of this situation, leave a comment and I'll try to clarify.

If you invest in your 401k or IRA, then you can also deduct that money from your taxable income.  (Up to the first $18,000 contributed to your 401k and the first $5,500 contributed to your IRA - unless you are over 55, in which case it becomes $6,500!)

So let's look at this example!

 

Understand Taxes in 10 Minutes

I'll use my own personal numbers which I anticipate seeing on my 2016 tax forms for the sake of realism and to show that this is a real skill!  My employer will pay me roughly $57,000 in salary over the course of 2016 and match my 401k contributions up to 9%, allowing me to get another 9% of salary, making me another $5,130 of untaxed income (untaxed until I withdraw it, at least)!  Out of that $57,000, I will lose $57,000 * .0765 = $4,360.50 to Social Security and Medicare taxes.  That means that my taxable income is $57,000-$4,360.50 = $52,639.50.  But wait!  I contribute to my 401k and IRA!  By maxing out my tax-deductible limit of $23,500, I can get my taxable income down to $52,639.50-$23,500 = $29,135.50!  But we aren't done yet - I still haven't applied my standard deduction!  After applying  the $10,400 standard deduction, I'm down to a taxable income of $29,135.50 - $10,400 = $18,739.50!

So $18,739.50 is the number we'll be using to calculate the amount owed to federal and state taxes.

Let's do federal taxes first.  If you glance down at that federal tax rate chart again, you can see that my taxable income falls into the second tax bracket.  That means that I only have two numbers to calculate!

Number 1:

  • I max out bracket #1 so I take it's upper end ($9,275) and multiply it by the bracket multiplier (10%) to get $9,275 * .10 = $927.50
  • I now subtract the upper dollar amount of the last tax bracket from my total taxable income to get $18,439.50 - $9,275 = $9,464.50.  This is the amount taxable in the second bracket!  It's not 15% of my whole taxable income, it's only 15% of everything over the $9,275 (as defined by the last tax bracket 'cut-off')!  By multiplying the second bracket tax rate of 15% to my remaining (currently untaxed) taxable income, I see that $9,464.50 * .15 = $1,419.68.
  • Now, I add up the total of all the brackets to get $927.50 + $1,419.68 = $2,347.18.
  • Assuming I make $57,000 and max out my retirement accounts, then $2,347.18 is the amount of taxes I will pay to the federal government for 2016.

Now, we still have to do this for state taxes, but the process is identical to calculating federal taxes.  Add the state and federal taxes and that's how much you owe.  If you've withheld more than that amount you will get a refund (withholding - total amount owned = refund/additional amount owed in taxes.)

And we're done.  It's that simple.  Now you can see that all you have to do is subtract, multiply a few times, and add calculate your taxes!  Stand tall from your financial summit as you've now conquered something most people fear and revere!  You have now attained income tax sage-ness!

 

Federal Tax Rate

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

39.6%

$415,050+ $466,950+ $441,000+

 

South Carolina State Tax Rate

South Carolina Taxable Income Rate
$0 - $2,910 0.00%
$2,910 - $5,820 3.00%
$5,820 - $8,730 4.00%
$8,730 - $11,640 5.00%
$11,640 - $14,550 6.00%
$14,550+ 7.00%

 

 

Readers, will you be getting tax refunds for 2015?  If so, what will you be doing with the money?  

 

-Phi

 

 

Posted in Education, Get Started, Personal Finance and tagged .

Leave a Reply