How Do Your Taxes Actually Work?

Summary/TL;DR

Total income is adjusted to reach adjusted gross income (AGI). AGI is reduced by the higher of the standard deduction or the sum of itemized deductions to reach taxable income. The part of taxable income attributable to ordinary income is taxed according to the marginal (not flat!) ordinary income brackets, while the amount attributable to long-term capital gains and qualified dividends are taxed at more favorable rates. If you are eligible, credits may be taken dollar-for-dollar against your tax liability.

Introduction

The US tax code is shrouded in mystery and is so poorly misunderstood that, sometimes, it hurts. Unfortunately, decisions are made every year by countless individuals based on these misconceptions that will cost them many thousands more in taxes than is necessary. While it is certainly complex, the basic concepts upon which the Leviathan tax code rests are relatively easy to understand and can go a long way towards helping one avoid mistakes at the least, and save a killing at the most.

The Basic Tax Formula

A summary of the income tax formula could be written as follows:

Total income (from all sources) is adjusted to reach adjusted gross income (AGI). Either the standard deduction or itemized deductions are applied to AGI, and the difference between the two yields taxable income. Based on the nature of the taxable income, it will go through one of two sets of marginal tax brackets. If it is income derived from long-term capital gains or qualified dividends, it will go through the long-term capital gains tax brackets. If it is ordinary income (essentially anything except a long-term capital gain or qualified dividend), it will go through the ordinary income tax brackets. This will result in one’s tax liability, which various tax credits can be deducted from on a dollar-for-dollar basis. The difference between your tax liability and any tax credits you are eligible for is your total tax. If you’ve paid in more than your total tax during the year, you will be issued a refund. If the opposite is true, then you will owe the difference and potentially an underpayment penalty.

Technically, there is an extra step towards the end in which one’s “other” taxes are calculated (which commonly include self-employment tax, net investment income tax, and the additional Medicare tax), but these are beyond the scope of today’s post. Unlike these “other” taxes, the high-level basics outlined above and below are applicable to everybody.

The Standard vs Itemized Deductions

A deduction is an amount of income you may exclude from your taxable income. In other words, they represent income that you will have earned for the year income tax-free. Everybody, regardless of their overall income level or how they spend their money during the year, is allowed a minimum deduction known as the “standard deduction”.

Deductions may also be allowed for various types of common expenditures, known as itemized deductions. Common examples include mortgage interest, charitable donations, and some of your state and local taxes. If the sum of your itemized deductions exceeds the standard deduction, then you will elect to itemize your deductions. It’s important to understand that your total itemized deductions must first reach the level of the standard deduction before having any positive impact on your taxes.

While adjustments to income and deductions from income are similar in that they are both eventually excluded from taxable income, adjustments will also reduce your adjusted gross income (AGI). Deductions, on the other hand, cannot reduce your AGI since they are only applied after it’s calculated. Furthermore, adjustments may be claimed regardless of whether or not you itemize your deductions. While this difference might seem nuanced, it is an important concept to understand in the world of tax planning because of the importance of one’s AGI to their overall tax picture.

Marginal (not flat!) Tax Brackets

One of the most common misconceptions about the American tax system is that it is flat and not marginal. People mistakenly assume that getting “bumped into the next tax bracket” means that all of their income will be taxed at a higher rate. In reality, only the amount that exceeds the bottom of a given bracket is taxed at the new rate. A visual example of this is below for someone with a $100,000 worth of taxable income:

As can be seen above, the first $23,200 worth of taxable income is taxed at 10%, the next $71,099 (from $23,201 to $94,300) of income is taxed at 12%, and only the $5,699 worth of income above the 22% bracket (whatever is above $94,301) is taxed at 22%. This results in a $12,106 income tax liability for the year, or about 12.1% of the $100,000 in taxable income.

Capital Gains vs Ordinary Income Taxation

Once it’s calculated, your taxable income is technically split into the following two categories: long-term capital gains plus qualified dividends, and everything else. The latter category is taxed according to the ordinary income tax brackets discussed above, while the former are taxed at far favorable tax brackets up, discussed below.

Unlike the ordinary income brackets, your long-term capital gains bracket is determined by your entire taxable income. What happens is something like this: your taxable income is determined according to the formula discussed at the top of this post. Then, your long-term capital gains and qualified dividends are taken out, leaving you with the amount of taxable income attributable to just ordinary income which is taxed at the ordinary income brackets. Your capital gains and dividends then go through the brackets shown above, starting with the bracket that your taxable income places you in. The sum of these two results is your tax liability for the year.

This part of the code is admittedly quite complex, so an example might help. Consider the scenarios illustrated below in which taxable income is $100,000 of solely IRA distributions, and $100,000 made up of 50% IRA distributions and 50% long-term capital gains (this example ignores deductions). In the first example, all $100,000 is taxed at the ordinary income brackets whereas the second example has only $50,000 being taxed at the ordinary income brackets. Furthermore, the second example has $39,250 of your long-term capital gains taxed at 0%! The end result here, despite the same levels of taxable income, is $5,000 less in taxes owed in Example 2 versus Example 1!

Here’s the key takeaway from this section – long term capital gains and qualified dividends are taxed at far more favorable rates than ordinary income. And if you engage in proactive tax planning, you can realize income at a 0% tax rate from your non-qualified accounts.

Knowledge Is Power

The key to making good tax decisions and engaging in sound tax planning is a healthy grasp of the basics. Teaming up with a proactive CPA and competent financial planner to take care of your tax planning will not only give you tremendous peace of mind, but can easily save you hundreds-of-thousands of dollars over a lifetime. When it comes to tax planning, knowledge is power!