How the heck do taxes work?

In the first four posts of the Personal Finance Basics series, we covered:

1. How will I know when I’ve saved enough to retire?
2. 401(k)s and pensions
3. The traditional IRA
4. The Roth IRA

As we covered in the posts for the 401k, the traditional IRA, and the Roth IRA, these accounts are awesome because they help you pay less taxes.

This leaves more money in your own pocket rather than Uncle Sam’s and is money you can use to shorten your road to financial independence.

Because of this, it’s critical to understand how income taxes work.

Income taxes in the United States

The Sixteenth Amendment, ratified in 1913, reads as follows:

The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.

In other words, the federal government said “We can take a portion of your income—no matter how it was earned—and we don’t have to share it with any state government.”

It’s this amendment that gave Congress the power to enact an income tax, which they did for the first time in October of 1913.

This first income tax was 1% on personal incomes over $3,000, with another 6% on incomes over $500,000. About 3% of the population was affected by it.¹

Our income tax today is similar, though more complex after more than 100 years of the knuckleheads in Congress messing with it.

Our tax brackets today

Here are the federal income tax brackets for 2022:

As you can see, how much you pay in income tax varies depending on your:

1. Filing status (married vs single vs head of household)
2. Annual income

How to calculate your taxes

For the sake of an example, let’s say you’re single, i.e., not married.

What the table above is saying, then, is that you’ll pay a:

• 10% tax on the first $10,275 you make
• 12% tax on every dollar between $10,276 and $41,775
• 22% tax on every dollar between $41,776 and $89,075

and so on.

So if you make:

• $8,000, you’ll pay 10% of this, or $800, in taxes
• $19,000, you’ll pay:
  • 10% on your first $10,275, which is $1,027.50²
  • 12% on the rest of your income
    • The rest of your income comes out to $8,725³
    • 12% of $8,725 is $1,047
  • Your total tax comes out to $2,074.50⁴
• $57,000, you’ll pay:
  • 10% on your first $10,275, which again is $1,027.50
  • 12% on your income between $10,276 and $41,775
    • There are $31,500 between $10,276 and $41,775⁵
    • 12% of $31,500 is $3,780
  • 22% on the rest of your income
    • The rest of your income comes out to $15,225⁶
    • 22% of $15,225 is $3,349.50
  • Your total tax comes out to $8,157⁷

As you can see, just because your salary of $57,000 falls in the 22% tax bracket, this doesn’t mean that you pay 22% of your income in taxes.

Put another way, every dollar you earn is taxed at a certain amount.

Dollar number 7,756, for example, falls in the 10% bracket. So on this dollar you’ll pay 10 cents in taxes.

Dollar number 89,544 falls in the 24% bracket; on this dollar you’ll pay 24 cents in taxes.

And dollar number 178,234 falls in the 32% bracket; on this dollar you’ll pay 32 cents in taxes.⁸

As you can see, the higher your income, the higher the percent that you pay in taxes.⁹

How to calculate your taxes faster

We can modify the tax brackets above to make it a bit easier to calculate our taxes.

Here’s the modified table for single / unmarried individuals:

(If you’re married, you can find this version of the tax bracket table on the IRS website.)

Now calculating our taxes is much easier.

Let’s say you make $57,000.

$57,000 falls in the 22% tax bracket, which reads:

$4,807.50 + 22% of the amount over $41,775

So you’ll pay:

$4,807.50 + 22% × ($57,000 - $41,775)

which equals $8,157 as we calculated in the previous section.

Reducing your taxes - Part 1

Now that you know how to calculate your taxes, we can throw in a slight curveball: deductions.

Deductions reduce your taxable income, lowering the amount of income tax you pay.

We’ll start with the standard deduction, which is one deduction that everybody gets.

In 2022, the standard deduction is $12,950 if you are single and double that—$25,900—if you are married.

So let’s again calculate taxes on a $57,000 income. This time, though, we’ll take the standard deduction into account.

The first thing we do now is subtract the standard deduction:

$57,000 - $12,950 = $44,050

With the standard deduction we’re only paying taxes as if we had made $44,050 rather than $57,000.

We check the table above and see that $44,050 still falls in the 22% tax bracket, which reads:

$4,807.50 + 22% of the amount over $41,775

So the taxes will be:

$4,807.50 + 22% × ($44,050 - $41,775)

which equals $5,308.

You just saved $2,849¹⁰ in taxes!

Reducing your taxes - Part 2

That’s pretty much it as far as calculating your income tax goes:

1. Take your income for the year
2. Subtract any deductions
3. Use the tax bracket table to calculate your income tax

As we’ve learned in the previous posts of the Personal Finance Basics series, though, the standard deduction is only the start of our deduction fun.

Our annual contributions to our 401k and to our IRA also count as deductions.

Let’s calculate taxes on a $57,000 income one last time, but this time let’s assume that we also maxed out our contributions to our 401k and our traditional IRA.

$57,000

- $12,950 (standard deduction in 2022)

- $20,500 (401k contribution limit in 2022)

- $6,000 (IRA contribution limit in 2022)

= $17,550

This is how you can take a $57,000 income and pay taxes on only $17,550 🎉

Now to calculate the taxes.

We check the table above and see that $18,950 falls in the 12% tax bracket, which reads:

$1,027.50 + 12% of the amount over $10,275

So the taxes will be:

$1,027.50 + 12% × ($17,550 - $10,275)

which equals $1,900.50.

You just saved another $3,407.50¹¹ in taxes!

Uncle Sam’s not done with you

Unfortunately, there’s one more tax to be paid: FICA.

FICA (Federal Insurance Contributions Act) is a tax used to fund Social Security and Medicare.

The FICA tax is 6.2% for Social Security and 1.45% for Medicare, for a total of 7.65%.

This means that on a $57,000 income, you’d pay $4,360.50¹² in FICA.

Sadly, there are no deductions here, though ideally you’ll see some of this money again when you become eligible for Social Security at the tender age of 67.¹³

Funds are leaving the Social Security and Medicare reserves faster than they’re being replenished, however, so who knows whether we’ll see this money again.

Don’t forget state income tax

I lied about FICA being the last tax.

It’s only the last national income tax, but the state government reaches into your pocket too.

If you live in any state except:

1. Alaska
2. Florida
3. Nevada
4. New Hampshire
5. Texas
6. Tennessee
7. South Dakota
8. Washington
9. Wyoming

You’ll pay a state income tax on top of your federal income tax.

State income taxes work similarly to the national income tax as far as tax brackets and deductions but vary from state to state.

You can calculate your state income tax using one of these calculators.

Summary

There you have it. You now know exactly how income taxes work in the U.S.

Become comfortable with calculating your income tax because:

1. Learning to reduce your taxes is a valuable tool in your personal finance toolbelt.
2. It’ll allow you to cheaply file your own taxes with software like TurboTax or TaxAct rather than paying an accountant $200+ for 15 minutes of their time.

Lastly:

• Try to max out your deductions every year by contributing all you can to a 401k and to a traditional IRA.¹⁴ This will reduce your taxes, which is like being handed free money.
• Use this calculator to double check your income tax calculations.

I hope this was helpful. Send me an email if you have any questions.

And if you’re looking to learn more, you can check out the whole Personal Finance Basics Series.

Video for this post

If you prefer watching to reading, here’s an easy-to-follow video I made with all this info:

Slides for this post

If you’re interested, check out the slides I made for the video.