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Making Your Savings Decisions

Taxes

Why Pay Taxes?

Taxes are mandatory contributions levied on individuals or corporations by a government entity – whether local, regional, or national.

Taxes provide revenue for governments to fund essential services – national defense, highways, police, a justice system – that benefit all citizens. Taxes also fund programs and services that benefit only certain citizens, such as Medicare, job training, schools, and parks.


Types of Taxes


Income Taxes
  1. Income taxes
  2. Payroll taxes
  3. Capital gains taxes

Property Taxes
  1. Property taxes
  2. Real estate taxes

Goods and Services Taxes
  1. Sales taxes
  2. Excise taxes
  3. User fees
  4. Sin taxes
  5. Luxury taxes


Income Taxes

Most individuals pay federal, state, and local income taxes.


Federal Taxes

The Internal Revenue Service (IRS) administers the federal tax system. The tax year for federal income tax ends on Dec. 31. If you earn income, you must file a Form 1040, 1040A, or 1040EZ to determine your tax liability by April 15 of each year.


States Taxes

As of 2022, Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming are the only states that do not have a state individual income tax.


Local Taxes

About a third of all states allow their counties, municipalities, and other local jurisdictions to impose an income tax. Tax rates are often lower than at the federal or state levels.

As of 2022, states with local income taxes are Alabama, Colorado, Delaware, Indiana, Iowa, Kansas, Kentucky, Maryland, Michigan, Missouri, New Jersey, New York, Ohio, Oregon, Pennsylvania, and West Virginia.


Tax Liability


Progressive Tax

Income tax is usually a progressive tax. The higher the taxable income, the greater the tax rate. Those income categories are called tax brackets.

There are seven federal income tax brackets for the 2023-2024 season: 10%, 12%, 22%, 24%, 32%, 35%, and 37%.

Your filing status (single, married filing separately, married filing jointly, etc.) and taxable income determine your bracket.

Income Tax Brackets in 2023 (Single Filing Status)
If taxable income is The tax due is
Not over $11,000 10% of taxable income
Over $11,000 but not over $44,725 $1,100 plus 12% of the excess over $11,000
Over $44,725 but not over $95,375 $5,147 plus 22% of the excess over $44,725
Over $95,375 but not over $182,100 $16,290 plus 24% of the excess over $95,375
Over $182,100 but not over $231,250 $37,104 plus 32% of the excess over $182,100
Over $231,250 but not over $578,250 $52,832 plus 35% of the excess over $231,250
Over $578,125 $174,238 plus 37% of the excess over $578,125

Table 10


Determine Your Preliminary Tax Liability

  1. Determine filing status (i.e., single, married filing separately, married filing jointly, etc.)

  2. Refer to the appropriate tax brackets and find your tax on base and tax rate.

  3. Apply the formula: Preliminary tax liability = Tax on base + Tax rate on excess × (Taxable income − Base)

Example: Determine Billy's Preliminary Tax Liability
  1. Billy's filing status = Single, and his taxable income = $31,000.

  2. Using the table above, his taxable income falls into the second tax bracket: tax on base = $1,100 and tax rate on excess = 12%

  3. Preliminary tax liability = $1,100 plus 12% of the excess over $11,000

$1,100 + 12% × ($31,000−$11,000) =

$1,100 + $2,400 = $3,500

Billy's tax liability: he owes $3,500 in taxes


Time to Practice: Preliminary Tax Liability

Let's help Alice determine her preliminary tax liability. Alice's taxable income is $54,725.

She is married and filing separately. Here are the relevant tax brackets for her filing:

2023 Married Filing Separately Tax Brackets
If taxable income is The tax due is
Not over $11,000 10% of taxable income
Over $11,000 but not over $44,725 $1,100 plus 12% of the excess over $11,000
Over $44,725 but not over $95,375 $5,147 plus 22% of the excess over $44,725

Table 11


Using the information provided above, help Alice figure out her preliminary tax liability.

Fill in the missing numbers

  1. Alice's tax on base = ____
  2. Alice's tax rate on excess = ____
  3. Alice's preliminary tax liability = $5,147 + 22% × ($54,725 − $44,725) = ____

Answers:

  1. $5,147
  2. 22%
  3. $7,347


Income Tax Planning

There is no obligation to pay any more in taxes than legally required. Tax planning seeks legal ways to reduce, eliminate, or defer income taxes.

To achieve this goal, you can 1. reduce taxable income, 2. apply for tax credit, or 3. combine these two.


Reducing Taxable Income

Your income tax is calculated based on your taxable income. Reducing your taxable income, not your total income, is the key to paying less income tax.

We must differentiate between total income, gross income, adjusted gross income, and taxable income.

inverted pyramid showing total income at the top and taxable income at the bottom after subtracting taxes, adjustments and de

Total income

All your income from any source received during the tax year, including:

  • Wages (i.e., selling labor)

  • Interest, dividends, and capital gain (i.e., selling capital)

    • Capital gains: Income earned when an asset is sold at a higher price than was paid for it

  • Rental property (e.g., second home) and intellectual right (e.g., patent)

  • Other income (e.g., alimony, gambling winnings, or prizes)

Gross income

Total income minus exclusions

Certain types of income, such as gifts that do not have to be reported, are called exclusions.

Examples of exclusions include:

  • Gifts
  • Inherited money or property
  • Life insurance benefits
  • Child support payments

Adjusted Gross Income (AGI)

Gross income subtracts contributions to individual retirement accounts (IRAs), alimony payments, interest paid on student loans, and other exceptional circumstances

Subtotal

Adjusted gross income minus deductions

Taxable income

Subtotal minus exemptions

Deductions

Deductions: Standard deduction and itemized deduction. The IRS adjusts the standard deduction for inflation for each tax year.

Standard Deduction Amounts for 2023 Taxes
Filing Status Standard Deduction 2023
Single; Married Filing Separately $13,850
Married Filing Jointly & Surviving Spouses $27,700
Head of Household $20,800

Table 12


The standard deduction is the simplest way to reduce your taxable income on your tax return. You simply claim a flat dollar amount determined by the IRS.

Here is what that means: If you earned $75,000 in 2023 and file as a single taxpayer, taking the standard deduction of $13,850 will reduce your taxable income to $61,150. Use the itemized deduction only when it is greater than the standard deduction.


Exemptions

Personal exemptions are based on the number of people supported by the taxpayer's income - one exemption each for the taxpayer, the spouse, and each dependent child. In 2017, for example, the exemption was $4,050 per person in the household. Personal exemptions have been eliminated beginning after December 31, 2017, and before January 1, 2026.


Reduce Your Preliminary Tax Liability

Final tax liability = Preliminary tax liability − Tax credits

Examples of tax credits are:

  • Health insurance premium tax credit
  • Hope scholarship credit
  • Section 529 college saving plan
  • Child tax credit
  • Retirement savings contribution credit
  • Mortgage interest credit


Six Steps to Calculate Your Final Tax Liability

  1. Determine your total income.

  2. Determine and report gross income:

    total income − exclusions

  3. Determine your adjusted gross income (AGI):

    Gross income − adjustments

  4. Determine your taxable income:

    AGI − Deductions (standard or itemized) − the value of your personal exemptions

  5. Determine your preliminary tax based on your filing status and tax brackets:

    Preliminary tax liability = Tax on Base + tax rate on excess × (taxable income - base)

  6. Determine your final tax liability:

    Final tax liability = Preliminary tax liability − Tax credit


Strategies to Reduce Income Taxes

Reduce taxable income through your employer.

  • Premium health insurance plan
  • Transportation reimbursement plan
  • Flexible Spending Account (FSA)
  • 401(k) retirement plan - Contribute to your employer-sponsored 401(k) plan at least up to the employer's matching contribution amount.


Make Tax-Sheltered Investments

A tax shelter is a legal place to store assets so that current tax liabilities are minimized. It may permanently reduce the tax amount or simply defer the taxes owed to a future period. Returns of tax-sheltered investments are tax-advantaged.


Examples of tax-sheltered investments:
  • Traditional IRA
  • Section 529 college saving plan
  • Government savings bonds
  • Capital gains on housing


How Tax Planning Fits Within Your Financial Plan

Ask yourself the following questions:

  • What tax savings are currently available to me?
  • How can I increase my tax savings in the future?
  • Should I increase or decrease the amount of my withholding?
  • What records should I keep?

Financial Plan Example
Category Current Situation Long-Term Plan
Gross Income $38,000 $38,000
− IRA Contribution $0 $5,000
= Adjusted Gross Income $38,000 $33,000
− Deductions $6,300 $6,800
− Exemptions $4,000 $4,000
= Taxable income $27,700 $22,200
Tax liability (based on applying tax rates to the taxable income) $3,693.75
 $2,868.75

Table 13


Then, revise your financial plan.

Approximate Total Tax Savings = $825.00 per year