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Ah, Tax Day. For a long time I asked myself the same question every April: why do I sometimes owe the IRS, and sometimes the IRS owes me? (Fun fact: tax withholding wasn’t even an option until the famous economist Milton Friedman suggested it in the 1940s.) I also wondered things like: what are exemptions? Should I itemize my deductions? Why are taxes and death the ONLY certainties in life?
Perhaps it goes without saying, but I was clueless. And maybe you are too. That’s okay. Allow me to give you a simple (yes, simple… taxes… oxymoron, I know) walk-through of IRS math, so you can make decisions now that may influence next year’s tax outcome—and possibly keep more money in your pocket.
To help explain, I’ll be using a fictional person: a young woman named Allison. She is a Colorado state employee who earns a gross income of $40,000 a year. She is unmarried, and has no children.
To do it for yourself, have your latest paystub handy and go to this tax calculator. Or just follow along with Allison. On the calculator, make sure to select Tax Year 2016, and choose your filing status. If you don’t know, answer a few questions here to find out (the quiz is for tax year 2015, but go with it). The goal of this exercise is to find out your annual tax liability, and then determine if you’re having just enough, too much, or not enough tax withheld from your paychecks. I’ll go line-by-line down the calculator.
We already know Allison’s status.
Next, enter your gross income. In other words, your annual salary without any taxes or deductions. This also includes interest earned in a savings account.
If you’ve earned any qualified dividends and long term capital gains, you would enter that next. This is for people that have money in a brokerage account like T.D. Ameritrade or Charles Schwab. If this applies to you, put in the appropriate number.
Adjustments are any portion of your income that is taken out of your paycheck before taxes. Examples of this are contributions to a qualified traditional retirement plan (like PERA), and, in most cases, the health care premiums you have deducted through an employer-sponsored plan.
If you’re a Colorado State Trooper, multiply your gross salary by ten percent. If you work under any other PERA-covered employer, multiply your gross salary by eight percent. This is your mandatory PERA contribution.
Alison: 8% of $40,000 = $3,200
If you contribute to a 401(k), 403(b), 457, traditional IRA, or other tax-deferred retirement account, multiply your gross salary by the percentage you contribute. If you contribute a flat dollar amount instead, multiply the dollar amount by the number of pay periods this year.
Alison: Contributes 3% of $40,000 into her 401(k) = $1,200
Add the PERA contribution and/or the tax-deferred retirement contribution(s) and put the sum into the Adjustments field. For Allison, that’s $3,200 in PERA contributions, plus $1,200 in traditional 401(k) contributions.
You are not paying income tax on these contributions yet. You will pay tax on the money when you retire (if you make contributions to a Roth 401(k), 457, or IRA, then those contributions are made after-tax). Your gross salary, minus the tax-deferred dollars, is your Adjusted Gross Income or AGI.
The Internal Revenue Code (IRC), the set of laws governing American taxes, gives everyone a tax break in the form of a deduction. You can either choose to claim the Standard Deduction, or itemize your deductions. The Standard Deduction for this year, depending on your filing status, is as follows:
Single or married filing separately: $6,300
Married filing jointly: $12,600
Head of household: $9,300
If you choose to itemize your deductions, you probably spent more than the Standard Deduction amount on things like mortgage interest, charitable donations, and medical expenses that exceeded 10% of your AGI.
For example, Alison is single and has no children. She spent a total of $1,700 on mortgage interest, charitable donations, and medical bills. She claims the Standard Deduction of $6,300 because that gives her a larger deduction than itemizing for $1,700.
An exemption is just like a deduction in that it reduces taxable income. You can control how many exemptions you claim on your W-2. The fewer you claim, zero for example, the more tax will be withheld in your paycheck. The more exemptions you claim, two for example, the less tax will be withheld.
You are able to claim an exemption for yourself, your spouse, and any ‘dependent’. There are rules around exemptions, so read this before changing anything.
In 2016, each exemption you claim is worth $4,050. If you claimed two exemptions for instance, $8,100 of your AGI would not be taxed.
The sum of your deduction and your exemptions will be reduced from your AGI. This number is your Taxable Income, or the amount of your income that you will be expected to pay tax on.
Alison is single with no dependents; she claims one exemption. Finally, she presses calculate.
To reiterate, your AGI is your gross income, minus your PERA contribution and other tax-deferred retirement contributions. Taxable Income is your AGI, minus your adjustments and deductions. Allison might have earned $40,000 in income, but only $25,250 is actually taxable. Finally, based on her taxable income amount, Allison owes $3,324 in 2016 Federal income tax.
As a state employee, Alison gets paid monthly. Her monthly tax liability is $277 ($3,324 ÷ 12).
Alison’s paystub tells her she is withholding slightly more than what she needs to. She breathes easy knowing that she will likely receive a small refund next year.
The question you might be asking is, “Where did the calculator get $3,324?”
It’s all about the tax brackets.
Even though Alison’s Taxable Income is $25,250, that doesn’t mean she owes 15% of her income in tax. That is her marginal tax rate, or the highest percentage that she’ll pay. She’ll pay the rate for each chunk of her income up to the highest amount in each bracket. The total amount she’ll pay, or the effective rate, is much lower than the marginal rate. Allison’s effective tax rate is about 8.3%.
It all comes down to educating yourself. I encourage you to play around with various tax calculators, read about exemptions, dividends, student loan interest—whatever applies to you. You’ll begin to see how the pieces fit together.
Knowing what you know now, will you be trying to reduce your refund next year? Leave your thoughts in the comments section.