Understanding and preparing for your taxes is a foundation of successful financial planning.
Of the six concepts that are foundational to long-term financial success,1 understanding and preparing for your taxes is the least pleasant. However, taxes are a crucial component of financial planning, as they can greatly impact your overall financial situation. In order to plan effectively for the present and future, it’s important to consider the tax implications of your financial decisions—tax planning is a significant driver in any successful financial plan.
Tax Obligations Found in Your Return
There are multiple tax regimes that you may need to satisfy in your annual tax return. These do not apply to all tax filers, so be sure you familiarize yourself with them and determine if they apply to your situation.2
Federal income tax: This is the tax that you pay on your income and includes wages, salaries, and investment income. The U.S. has a progressive tax system—individuals pay a higher percentage of their income in taxes as their income increases.
State income tax: Depending on where you live, you may also be required to pay state income tax on your earnings. The rules and rates for state income tax vary by state.
Social Security and Medicare taxes: These taxes are taken out of your paycheck to fund Social Security and Medicare programs. For wage earners, the combined rate for these taxes is 7.65% of your earnings; if you are self-employed, you are responsible for both the employer and employee portions of these taxes, which is a total of 15.3% of your net earnings from self-employment.
Property tax: If you own a home, this is a tax you will pay based on the value of your real estate. Property tax rates vary by location, and are deductible.3
Estate and gift tax: This is a tax that is applied when you transfer assets from one person to another. It applies if you have a large estate or make large gifts to others.
It would be quite tough to address all five topics in this Stack, especially considering that taxes can already be a dry subject matter. Therefore, we will concentrate on the topic of Federal taxes this week, and address the other remaining taxes in a subsequent Substack.
Federal Income Tax — Possible Reductions & Estimated Amount
When planning your tax liabilities to Uncle Sam, you need to decide what deductions you are going to take before you can determine the amount of tax owed to the IRS.
Will you take a standard deduction or itemize your deductions?
The federal government allows you some deductions from your taxable income which can help reduce the amount of income tax you owe to the government. Deductions are subtracted from your gross income to arrive at your taxable income. When filing your tax return, you have the option to take either the standard deduction or to itemize your deductions.
Standard deduction: This is a fixed amount that taxpayers can subtract from their taxable income. The standard deduction amount varies based on filing status, age, and other factors. For example, for the 2023 tax year, the standard deduction for a single filer is $13,850, while the standard deduction for a married couple filing jointly is $27,700.4
Itemized deductions: In lieu of taking the standard deduction, you may choose to itemize your deductions. This means you will list out specific expenses that you incurred throughout the year that are eligible for a deduction. Common itemized deductions include state and local taxes, mortgage interest, charitable contributions, and medical expenses.
Which one should you take?5
Your financial situation will dictate which one is more favorable—meaning, which one leads to the highest amount of available deductions, reducing your gross income, and reducing your overall tax bill. Generally, here is what you should consider when making the decision:
Standard deduction: If your taxes are relatively straightforward—you have very few deductions such as property taxes or charitable giving—you may want to opt for the standard deduction as it’s simpler to calculate. (The majority of filers apply the standard deduction.)
Itemized deductions: Itemizing deductions is more complex and time-consuming, but is beneficial if you do have a lot of deductions and together they are higher than the standard deduction.
A general rule of thumb is once you obtain real property—such as a residence or rental property, you will want to determine if itemized deductions are more beneficial to you.
Other Ways to Reduce Your Gross Income
In addition to applying a standard or itemized deduction, there are other ways to reduce your gross income—therefore reducing how much you are going to pay:
Pre-tax retirement contributions: Contributing to a qualified retirement plan, such as a 401(k) or individual retirement account (IRA), can reduce your taxable income. Contributions made with pre-tax dollars are deducted from your gross income, lowering your taxable income. (For example, if you make $50,000 per year, and contribute $5,000 to a pre-tax retirement account, your taxable income will be reduced to $45,000.)
Health savings account (HSA) contributions: Contributions to an HSA can also reduce your taxable income. Like a traditional 401(k), HSA contributions are made with pre-tax dollars, reducing your taxable income.
Tax credits: Credits, such as the Earned Income Tax Credit and Child Tax Credit, can also reduce your taxable income.
Business expenses: If you are self-employed or a small business owner, you may be able to deduct business expenses, such as office supplies, rent, and equipment, from your gross income.
After Applying Your Deductions, Estimate How Much You Will Owe
Once you have applied your deduction(s) you can now determine how much you will owe to the Federal government by applying their tax rates to your income after deductions.
The tables illustrate below how the progressive tax system is applied—it divides income into different brackets or ranges, with each range being subject to a different tax rate. For example, the first $11,000 of income is taxed at 10%, the next $11,001 at 12%, and so on. As a person’s income increases, they move into a higher tax bracket, where they will pay a higher tax rate on the additional income earned above the threshold.
Understanding the basics of federal income tax and how much you owe Uncle Sam is vital to managing your cashflow and planning your finances. Deductions play a crucial role in reducing taxable income and lowering the overall tax burden—so make sure you understand where you could take advantage of deductions and if you should itemize or take the standard deduction. By utilizing deductions and understanding the tax rates, you can effectively manage your tax liability and keep more of your money.
Next week we will address the remaining taxes not covered here: state income taxes, Social Security & Medicare taxes, property taxes, and estate and gift taxes.
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6 Foundational Basics: Budgeting & Lifestyle Management, Debt Evaluation & Payoff Planning, Emergency Fund Creation, Understanding & Preparing for Taxes, Retirement Planning Basics, Planning For Advanced Financial Goals
It’s worth noting that not all individuals are required to pay all of these taxes, and the rules and rates for each tax can vary depending on individual circumstances.
Deductibility of property taxes: The amount of property tax that can be deducted is subject to a cap. As of the 2021 tax year, the state and local tax (SALT) deduction, which includes property taxes, is limited to $10,000 for both individuals and married couples filing jointly. This means that if you pay more than $10,000 in property taxes, you can only deduct up to $10,000 of that amount on your federal tax return.
When preparing to file their tax return, individuals should evaluate their specific financial situation to determine whether taking the standard deduction or itemizing deductions would result in a lower tax bill.