Personal Guide to US Taxpayer - 1

Only two things in certain are death and taxes. When you make money, a sizable chunk gets taxed. And as bizarre as it is, you’re not taxed right away, it all happens once a year. Tax law is quite complicated, and always, always consult a professional on this, read this for a brief, lacking overview. 

 

One thing to note before we go on the details - tax is different maybe for different people, so my examples will not necessarily be fitting for you. Also, tax is `charged’ differently for different `tax filing status’ - there’s single (yayy), married filing jointly, married filing separately, head of household, and qualifying widow(er) with dependent child. These statuses come with various qualifications, so make sure to check them before you file your taxes. Given these statuses, you might have different laws and numbers. For this book, I’ll just assume yall single. But generally, the process should be similar.

 

Another thing to note is that this is for an `average laborer`, meaning that you work for a living. If you live off of investments, or have your own business or something, this probably does not apply to you. Some people (including myself) want to retire early with a sizable retirement portfolio, and their tax procedures are quite different.

 

Before I start, I’d like to clarify that I am in no ways a professional, and just a dude talking about his experience. I’m not giving out financial / accounting advice.

 

From your job

Usually what would happen is that your job will take away a bunch of money for various purposes. First, the total amount you earn is your `Gross pay’. It’s what you say you get paid. If you get paid 95k a year, that’s your gross yearly salary. That’s my gross salary. Let’s see how this seemingly sizable salary gets skinned off. Here’s the list of things that generally get taken off of your gross pay:

1. Federal income taxes

2. State income taxes

3. Social security and medicare

4. Insurance 

5. Pre-tax contributions

It’s a long ass list, I know. After all this, what is actually put in your bank account is your net pay. Also, these are done in a super weird way. Let’s elaborate on these fuckers and how they work.

 

You have your gross pay, and we take out social security (6.2%) and medicare (1.45%). If it makes you feel better, your employer pays the social security and medicare as well, meaning that the government receives 12.4% and 2.9% of your gross pay for social security and medicare. This is the Federal Insurance Contribution Act (FICA) tax that you pay. What the hell is this and why are we paying so much? I’ll explain this later. After this, they take out your part of the insurance premium, and your retirement contributions (usually 401k). The retirement contribution is up to you, and there’s a maximum at $19,500 per year cap for 2020. The good thing about this is that this amount is tax-deductible, meaning that you don’t pay on the amount that you paid to your 401k. Then, the company will `withhold’ the federal and income taxes for you. Then you get whatever is left of this poor, beat-ass gross pay of yours, and that’s your net pay, or what shows up in your bank account or check.

 

I’ll show you my example. Below is my table for a 2-week worth of salary. If you want to see yours, your employer would have something called a pay stub, which shows the treacherous journey your gross pay undergoes. This is without the 401k contributions, because I just didn’t make any contributions. 

	Value ($)	description	Remaining ($)
Gross pay	2264.25	Hourly rate * hours worked
Pre-tax	64.26	Medical, dental, vision, drugs	2199.99
Taxes	458.17	Federal, social security, medicare	1741.82

 

As you can see, a sizable chunk of the money is taken out. Of course, come tax season, depending on how much you already paid in taxes, you can get some of them if you overpaid, which is an awfully weird tradition, in my opinion. I’ll also explain this later.

 

Tax return

I may just be grumpy, but I hate how people make things sound like they’re doing you a favor while it’s your goddamn right - and no example is better than tax returns. It gives us the illusion that we are getting something from the government, that, the government, in its generous mercy, is giving us some money, like it did something really well and now has money to give back to the people. That cannot be further from the truth. It’s something we overpaid. It’s like if my rent was $500 but I kept paying $600 every month, so I get $1,200 back at the end of the year. Yay! Not really.

 

My rant aside, tax season usually starts in February, and ends in mid-April. Generally, what happens is that employers will give you a form called W-2, that lists the money you made, and how much tax you already paid. If you’re a simpleton (only source of income is from a job) like me, that’s really all there is, and you’re ready to file your taxes. Here’s an example of mine:

 

	Wage	Taxes withheld	rate
Federal tax wages	47406.26	6407.98	13.52%
Social security wages	47406.26	2939.19	6.20%
Medicare wages and tips	47406.26	687.39	1.45%

As you can see, for social security and medicare, the expected amount was paid. So no return or anything. For federal taxes, it gets a bit complicated. Also note that I don’t pay state taxes because I live in Tennessee (Yeehaw). This is how your federal tax rate is calculated:

 

Income - deductions = taxable income

Apply tax bracket function to taxable income = total tax that has to be paid

Tax withheld (already paid) - Total tax that has to be paid + tax credit = tax return

 

Let’s break this down.

 

Income - deductions = taxable income

You see the number there for federal tax wages? 47,406.26. We subtract some amount before that gets `taxed’. There are two choices - standard and itemized deduction. You can’t get both. If you don’t have anything weird, like own a property, pay a lot in state taxes, donate a LOT of money to charity, or have a medical bill - standard is probably the way for you. Standard is just one amount that you get to take off, just because. For 2020, it’s $12,200 for me (single tax status). It’s different for other statuses - if you’re married, it’s double that, and if you’re a head of household, it’s about 150% of the single amount. So in my example, my taxable income would be 47,406.26 - 12,200 = $ 35,206.26.

 

If I were to take the itemized deduction route, it gets quite complicated. Conceptually, itemized deductions are things that the government wants you to do - so they reward you by giving you a tax `cut’ (heard about these, right?). The reason they are itemized is because there are a lot of things you can get deducted for, and you can sum them up. Note that you only do this when your sum is higher than the standard deduction (i.e. If your itemized deduction is less than 12,200, I will just go with the standard deduction). The items for deduction include, but not limited to:

1. Mortgage interest

2. Charitable contributions

3. Medical expenses (lot of rules with this, like it has to exceed a certain amount)

4. State and local taxes

So the sum of all these exceed the standard, you’d go with the itemized. Note that these categories and the laws, qualifications, and maximum amounts and all that changes year by year. It’s a mess, I know. For some homeowners, they might pay a lot for mortgage interest and property taxes (also included for item 4), so it makes sense for them to go with the itemized deductions.

Apply tax bracket function to taxable income = total tax that has to be paid

Now that I’ve deducted my standard deduction from my wage, it’s time to apply the tax function on my $ 35,206.26.  I’ll go through mine. Below is an example tax bracket table:

 

Tax Rate	Single	Married (Filing Jointly)	Head of Household
10%	$0 to $9,875	$0 to $19,750	$0 to $14,100
12%	$9,876 to $40,125	$19,751 to $80,250	$14,101 to $53,700
22%	$40,126 to $85, 525	$80,251 to $171,050	$53,701 to $85,500
24%	$85,526 to $163,300	$171,051 to $326,600	$85,501 to $163,300
32%	$163,301 to $207,350	$326,601 to $414,700	$163,301 to $207,350
35%	$207,351 to $518,400	$414,701 to $622,050	$207,351 to $518,400
37%	$518,401 and higher	$622,051 and higher	$518,401 and higher

 

Since I’m single, and my taxable wage is 35,206.26, my highest tax bracket will be 12%. The equation is follows:

 

(9,875 * 0.10) + (35,206.26 - 9,875)(0.12) = $ 4027.25

 

Alright, this is what happened. You start from the lowest bracket. You fill it up, and if your taxable income exceeds that bracket, you go to the next. So I filled out the 10% bracket, and part of the 12% bracket. Note that the higher rate of 12% is applied to what’s left over (35,206 - 9,875 = $ 25,331.26). If I had a taxable income higher than $ 40,125, I would pay 22% on whatever amount over 40,126. If you’re curious, whatever tax you need to pay divided by your taxable income is your `effective tax rate’. In my case it would be 4,027.25 / 35,206 = 11.43 %, which makes sense because it’s between 10 and 12.

 

So for federal taxes, I was supposed to pay $ 4,027.25, and I already paid (explained before) $ 6,407.98. Jeepers.

Tax withheld (already paid) - Total tax that has to be paid + tax credit  = tax return

This part is quite easy. 6407.98 - 4027.25 + 0 = $ 2380.73. That’s how much I’ll get back come tax season. That’s a lot, isn’t it? The feeling of getting a chunk of money once a year is cool, but you’re also missing out on your paycheck every month. 

 

What is this tax credit you ask? Tax credits are dollar-for-dollar reduction in your to-pay-tax. So it directly reduces the `total tax that has to be paid’ amount (different than deduction, where it reduces the tax`able’ amount). There are many types of tax credits. The most common types of credits are from getting solar panels for your home or getting an electric vehicle (it seems like this one is on its way out), or adopting children. You also get tax credits for having children ($2,000) per dependent, with adjustments with income level (> $200,000 per single).

 

So this is tax, for simple laborers. You’d have all these values and you’d create a form 1040, which is the form you send to the IRS. I recommend using some free software to do so, and not do it in pen and paper and mail it like a caveman. Just google file taxes for free, and you can find numerous sites that can help you. If you’re feeling fancy, or if your situation is a bit more complex (e.g. you have an inheritance, you made a lot of interest, you have property), I suggest paying for a more premium tax software. They’re usually on sale from late January to February. I personally use turbotax, because it allows me to import all my investment earnings (and losses) automagically. It’s quite nice. You know what would be nicer? If turbotax paid me to say this. They did not.