In this week’s post, I explain the basics of income taxes. I know what you are thinking – “taxes…how boring…this will be a perfect post to skip.” I understand the sentiment and agree that taxes can be unpleasant, but it is very important to understand at least the basics of how income taxes work.
It is important to understand the basics of how income taxes work for several reasons:
Christians are commanded to pay taxes:
Romans 13:6-7 – For because of this you also pay taxes, for the authorities are ministers of God, attending to this very thing. Pay to all what is owed to them: taxes to whom taxes are owed, revenue to whom revenue is owed, respect to whom respect is owed, honor to whom honor is owed.
Matthew 22:17-21 – “Tell us, then, what you think. Is it lawful to pay taxes to Caesar, or not?” But Jesus, aware of their malice, said, “Why put me to the test, you hypocrites? Show me the coin for the tax.” And they brought him a denarius. And Jesus said to them, “Whose likeness and inscription is this?” They said, “Caesar’s.” Then he said to them, “Therefore render to Caesar the things that are Caesar’s, and to God the things that are God’s.”
If we are commanded to pay taxes, it is wise to understand what we are required to pay.
Understanding the basics will also allow us to be on the same page as we explore tax reduction strategies in future posts.
Before we get started, I do want to point out that this post will give a very basic introduction. The tax code has many exceptions that result in things getting complicated very quickly. This introduction will keep things simple, and all exceptions will not be mentioned. Also, all numbers and examples will assume it is tax year 2021. The post will solely focus on federal income taxes, and we will not cover payroll taxes, state income taxes, etc.
Simplified federal income tax formula
As mentioned above, our federal tax code has a lot of intricacies. However, here is the basic formula:
Start with all income. Subtract adjustments to arrive at adjusted gross income (AGI). Subtract tax deductions to arrive at taxable income. Taxable income is then run through the tax brackets to calculate tax before credits. Subtracting credits results in tax after credits. Subtracting payments already made results in amount due or refund owed.
Before we explore this formula in more detail, it is important to know that there are different filing statuses when filing a federal tax return. A filing status is a classification that impacts many different parts of a taxpayer’s return, including: bracket/rate schedule, standard deduction, certain itemized deduction thresholds. For example, for tax year 2021, a taxpayer with single filing status pays 10% on taxable income from $0 to $9,950, whereas taxpayers with married filing jointly status pay 10% on taxable income from $0 to $19,900. Filing status depends on marital status and number of dependents. There are five different filing statuses: single, married filing jointly, married filing separately, head of household (single with dependents), qualifying widower. Single and married filing jointly represent a vast majority of returns. A detailed explanation of each status is beyond the scope of this post.
Below we will now explore the simplified income tax formula in more detail.
Income
Income includes money received from a variety of sources. These sources include: compensation for work (reported on W-2 or 1099), interest, dividends, IRA distributions, pension and annuity income, some social security benefits, capital gain or loss, business income, real estate.
Income example
Mary will file with single filing status. In 2021, she earned $95,000 at her job as a marketing manager. She also received $7,000 in interest from bonds she inherited from her grandmother. Mary’s total income is $102,000.
Adjustments
Adjustments to income are things that reduce your adjusted gross income (AGI). These are commonly referred to as “above the line” deductions. Some examples of common adjustments are: IRA contribution deduction, student loan interest deduction, health savings account (HSA) deduction, self-employed retirement plan deduction, self-employed health insurance deduction.
Adjustments example
Mary’s employer does not offer a retirement plan, so she made a $6,000 contribution to a traditional IRA. She also made a $2,000 contribution to her health savings account (HSA). Her total adjustments were $8,000.
Adjusted gross income (AGI)
The difference between a taxpayer’s income and adjustments is their adjusted gross income (AGI). AGI is important, because the availability of other deductions and credits depends on the level of AGI.
Adjusted gross income (AGI) example
Mary’s adjusted gross income (AGI) is calculated by subtracting her adjustments of $8,000 from her total income of $102,000. This results in adjusted gross income (AGI) of $94,000.
Deductions
After calculating adjusted gross income (AGI), you subtract the larger of either a standard deduction or itemized deductions to calculate taxable income.
Standard deduction
A standard deduction is a set amount you can deduct if you do not have any itemized deductions, or the amount of your itemized deductions is smaller than the standard deduction. These set amounts for 2021 were $12,550 for the single filing status and $25,100 for married filing jointly.
In addition to these set amounts, taxpayers using the standard deduction can also take a small, separate deduction for charitable contributions. These deductions are capped at $300 for the single filing status and $600 for married filing jointly.
Itemized deductions
Itemized deductions are certain expenses or other financial transactions from throughout the year that are deductible. Common itemized deductions include: medical and dental expenses (above 7.5% of AGI), state and local taxes ($10,000 cap), interest (mortgage and investment), gifts to charity, casualty and theft losses.
Again, taxpayers only itemize if the combined total of their itemized deductions is greater than the standard deduction.
Qualified business income deduction
The qualified business income deduction is another deduction that applies to small business owners. A detailed description of this deduction is beyond the scope of this post. The qualified business income deduction can be taken by both taxpayers who take the standard deduction and those who itemize.
Deductions example
Mary paid state and local taxes of $4,000 and gave $11,000 to her church. Would Mary use the standard deduction or itemize? Mary would itemize, because her itemized deductions of $15,000 are greater than her standard deduction and separate capped charitable deduction of $12,850.
Taxable income
Subtracting all deductions from adjusted gross income (AGI) results in taxable income.
Taxable income example
Mary’s taxable income is $79,000. This is calculated by subtracting her itemized deductions from her adjusted gross income (AGI).
Calculate tax before credits using brackets
To calculate the total tax owed before credits, you would run the taxable income through the various tax brackets. For example, a taxpayer with single filing status will pay 10% on taxable income from $0 to $9,950, 12% on taxable income from $9,950 to $40,525, and so forth. There are many exceptions to this, including special treatment of capital gains and a variety of other special taxes. Here is the schedule of brackets for the single filing status:
Calculate tax before credits using brackets example
Given that all of Mary’s $79,000 of taxable income is ordinary income, we calculate her tax by putting it through the brackets. This results in total tax before credits of $13,129 (10% * 9,950 + 12% * 30,575 + 22% * 38,475).
Credits
Tax credits reduce tax liability dollar-for-dollar. If a taxpayer owes $800 in tax and has a $200 credit, they would then owe $600 in tax (800 – 200 = 600). A credit is different from a deduction, because credits reduce tax and deductions just reduce taxable income. Some credits are even refundable, meaning that they will be given to the taxpayer even if no tax is owed. Some common credits include: child tax credit, foreign tax credit, various education credits, child and dependent care tax credit, earned income tax credit, savers tax credit, adoption credit, residential energy credit.
Credits example
Mary had a residential energy credit of $500. This was her only credit.
Tax after credits
Total credits are subtracted from tax before credits to arrive at tax after credits. It is important to note that this is the actual amount that the taxpayer is paying in tax, even though the amount owed or refund received when filing may differ based on the amount of prepayments.
Tax after credits example
Mary’s tax after credits is $12,629. This is calculated by subtracting her total credits of $500 from her tax before credits of $13,129.
Payments made
Payment is typically made toward a tax liability throughout the year through withholdings from paychecks and estimated tax payments. Even though paying throughout the year might not “hurt” as much as making a very large payment when filing, it is important to remember that the amount of tax that is ultimately paid is the same (except for underpayment penalties, which we will not cover here).
Payments made example
Mary had $10,000 withheld from her paycheck and made estimated payments of $2,000. Her total payments made are $12,000.
Amount due / refund
Subtracting total payments made from tax after credits results in amount due or refund amount.
Amount due / refund example
Mary owes $629. This is calculated by subtracting total payments of $12,000 from her tax after credits of $12,629.
Calculating Mary’s taxes (all examples shown together)
Below is Mary’s simplified tax calculation, combined from all the examples above. As mentioned, because of the complexity of the tax code, this example is overly simplified, but it still lays out the basic structure.
If you have any comments, questions, or ideas for future posts, please let me know
I hope you found this introduction to federal taxation helpful and educational. If you have any comments, questions, or ideas for future posts, please let me know. You can reach me directly via email at crawford@ulmerfinancial.com.
Comments