When you think of your most substantial expense this year what do you think? The majority of people might say housing, or maybe tuition/student loans, or a car.The crazy part is that people forget that taxes is probably their most significant expense (or at least one of the biggest).
Before you start complaining about how much you owe or how much you paid in the past, you should know that you have more control of your taxes then you might think.
Take some time to understand how our tax system works. Then make an intentional decision to lower one of your most significant expenses today. Taxes are due every year, so you might as well take an interest now to save yourself in the future.
First, take a look at your most recent pay stub.
To get you taxable wages you need to take your gross income and subtract any pre-tax deductions you might have. Examples of pre-tax deductions would be traditional 401k (not Roth), 403b, Health/dental/vision insurance, HSA/FSA, dependent care, or life insurance (if on payroll deduction). This number should equal what your paycheck shows for “Taxable Wages.”
Note: Social Security (FICO) and Medicare taxes are separate then your taxable wages. The only way to lower Social Security (FICO) taxes is to enroll in payroll deductions for an HSA (Health Savings Account).
On your pay stub, you should see the current pay stub’s taxable wages and the YTD (year to date) amount. To get your end of year taxable income take your YTD taxable wages, and add the remaining pay cycles remaining the current calendar year.
Example for Average Joe: Today is October 12th, 2017 – his YTD taxable income is $40,000, each pay cycle his taxable income (gross – pre-tax deductions) is $1500, and he is paid bi-monthly.
$40,000 + ($1,500 * 5 pay cycles left this calendar year, 1 more in October and 2 in November and December) = $47,500 in Taxable Income.
**Don’t forget to add taxable income from other jobs or side hustles if applicable**
Federal Income Taxes
Now that you have your yearly taxable income, next you will need to know how much federal income tax you have paid or will pay by the end of the year (through your job(s)).
Identifying your federal income tax is pretty simple. First, take out your pay stub again and look for the “federal withholding” or “federal income tax.” There should be the current pay cycle amount and the YTD amount.
Just like above, take the YTD amount and add in the remaining pay cycles until the end of the year.
Example for Average Joe: the same date as above, YTD Federal Income Tax paid is $5,000 and each pay cycle you pay $300 in federal income tax.
$5,000 + ($300 * 5 pay cycles left this calendar year) = $6,500
So now you have the two numbers you need to begin your calculations to see how much you will owe or get refunded in tax season.
Tax Brackets & Calculating What You Will Owe
Are you a single filer, married, or married filing separately? Tax brackets are different depending on your situation.
Continuing our example from above, let’s say Average Joe is a single millennial working his first job out of college. In 2017, Joe made $47,500 in taxable income and paid $6,500 in federal income taxes from his job.
One deduction Joe qualifies for is the student loan interest deduction (1098-E). Joe paid over $2,500 in student loan interest in 2017, and his modified adjusted gross Income (MAGI) doesn’t exceed the limits, so he is eligible to deduct $2,500 from his taxable income.
Updated Taxable Income: $45,000
To calculate how much Joe will owe or get refunded we will need to look at the current tax brackets.
Before we start, we should identify the standard deduction, personal exemptions, and any tax credits Joe might have. For our example, Joe is taking the standard deduction with a personal exemption. He doesn’t have any tax credits (like the child tax credit for example).
Standard deduction for a single individual in 2017 – $6350
Personal Exemption for a single individual in 2017 – $4,050
Joes Free Money – $10,400
His “free money” means if Joe only made $10,400 in taxable wages this year he wouldn’t have to pay any taxes.
For a single individual, the next $9,325 is taxed at 10%
So Joe has $10,400 in free money + $9,325 taxed at 10%
Taxes owed thus far ($19,725 in income * .10) = $1,972.50 owed in the 10% bracket
15 % bracket
The 15% bracket covers the range of $9,326 to $37,950 – which is the next $28,624.
Since Joe’s Taxable income is $45,000 and his 10% money is at $19,725, all we have to do is subtract these numbers to get the taxable income taxed at 15%.
($45,000 – $19,725) = $25,275
$25,275 * .15 = $3,791 in taxes owed in the 15% bracket
Add Up totals from 10% and 15% brackets
So based on Joe’s income, he will owe:
$1,972.50 from the 10% bracket
$3,791 from the 15% bracket
= a total of $5,763.50 in Federal income taxes based on the 2017 tax brackets.
Follow the same calculations in the next tax brackets (25%, 28%, 33%, etc.) to calculate your situation
Since Joe has already paid $6,500 in Federal Income tax through his paychecks, he should expect a refund of $736.50.
($6,500 – $5763.50) = $736.50
When you start a new job, you choose your allowances in the W-4 tax form. For a single person typically the recommendation for allowances is 0-2. Having 0 allowances means there is more money withheld from your paycheck. Also, a more significant tax refund during tax time. You can better adjust your allowances on your W-4 form when you make a plan for your taxes.
In Joe’s situation, I would recommend that he raise the allowance from 0 to 1 or from 1 to 2. Doing so would reduce the amount of money withheld from his paychecks.
When you get a big tax refund, it means you are giving the government an interest-free loan. Giving the government a tax-free loan doesn’t make much sense when this money could be putting that money to better use. You could invest in an Index fund for example and earn an average of 7% interest on average.
After planning for your taxes, it would be most effective if you didn’t owe anything and didn’t get a big refund either. I would recommend planning for a few hundred dollar refund to be on the safe side.
Ways to Lower Your Taxes
The best way to keep your taxable income low is to invest in tax advantage accounts. These accounts include retirement accounts like 401k, 403b, 457, Traditional IRA (SEP IRA and SOLO 401k for self-employed people).
401k, 403b, 457 – You can contribute $18,000 a year as a single person. (457 accounts are for state/government workers). You can add extra $6k a year if you are over 50 years old.
Traditional IRA – You can add $5,500 a year and can deduct from taxable income if your modified adjusted gross income (MAGI) is less than $61k a year. If you are above $62k and below $72k, you can qualify for a partial deduction.
HSA – Health Savings Account – $3,400 for a single individual
That means if you have a regular 9 to 5 corporate job with a 401k, HSA, and Traditional IRA you could deduct $26,900 from your taxable income.
In our example, if Joe maxed out these three buckets his taxable income would go from $45,000 to $18,100.
$45,000 Taxable Income
- $18,000 from 401k
- $3,400 from HSA
- $5,500 from Traditional IRA
= $18,100 in taxable income after pretax bucket deductions
After his “free money” of $10,400, he would be taxed the remaining $7,700 in the 10% bracket.
$18,100 – $10,400 (Free Money from standard deduction and 1 personal exemption) = $7,700 taxed at 10%
So he would owe $770 in taxes rather than $5763.50
By making the intentional decision to max out his 401k, HSA, and Traditional IRA he will save nearly $5k in taxes. The math is powerful!
Once you understand the basics of how our tax system works, it’s relatively easy to calculate your numbers and plan for your taxes. Now that I know, I can more efficiently plan my year and decrease my most significant expense. Reducing my top expenditures was the way I fast-tracked myself out of student loan debt. Now that I am debt free, I will continue to decrease my most significant expenses so I can invest in things that build wealth. Make the intentional decision to plan for your taxes each year, and you will reap the benefits tenfold.
Question for You!
What is your most significant annual expense?
What have you done to reduce that cost?
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