EPT
The way taxes work for most people is that you do whatever you want for a year and then at the end of it turbotax/your accountant tells you how fucked you are. But fortunately you massively overpaid in taxes anyway so you still get money back. This approach is bad. I'm going to look at income taxes and capital gains here because they're the ones I give a shit about but first a little tax theory about progress, flat and regressive taxes and how those apply to income taxes, sales taxes and capital gains.
+ Show Spoiler [Progressive, flat and regressive, an e…] +
Taxes can be progressive, flat or regressive. A progressive tax seeks to tax people according to their ability to pay and is the most common system used for income taxes in the first world. A flat tax simply takes the same proportion of the income of everyone, regardless of ability to pay. A regressive tax taxes the poor at a higher rate than the rich.
The United States Federal Income Taxes work on a progressive system like those of most of the world with a series of increasing percentage bracket. Everything you earn up to the 9,225th dollar is taxed at 10%, the 9,226th dollar is taxed at 15% without in any way impacting the tax of the first 9,225. The way this system works is that an increase in taxable income does not, and can not, decrease your post tax income. The stepped nature of it also works well to protect necessary income to survive. If we assume that a human must first buy food, water, shelter and so forth then having an amount of money that would cover those barely taxed is pretty reasonable. Everyone needs those things so the money that covers them is at 0% to 10%. Car payments, eating out, that kind of stuff is 10% to 15%, vacations nearer 25% and so forth. The very first $10,300 you earn isn't covered by any of those brackets as it is not taxable income so slips by at 0%.
While it is possible that a pay increase could result in your AGI disqualifying you for a big tax credit or benefit, so a pay raise could result in you being poorer (although not due to the progressive income tax structure) putting that pay raise into retirement funds, a FSA or a number of other options would protect your AGI.
However, in addition to Federal Income Taxes there are also a lot of states with sales taxes at a fixed percentage. This seems, on the face of it, a flat tax but in practice it is very regressive because it is a tax on consumption and consumption is often involuntary and uneven across income classes. Let's assume that it costs $20,000 of consumables (rent/gas/food/utilities) for a family to survive. If your family earns $30,000 and there is a 10% sales tax then you're paying $2,000 on top of your $20,000 just to survive. Taxes have taken 20% of your discretionary income of $10k and 6.7% of your gross. A richer family that earns $70,000 a year spend the same $20,000 on forced consumption with $2,000 tax. For them that same $2,000 represents a 4% tax on their discretionary income and a 2.8% tax on their gross. Now they may go on to spend every remaining dollar they have on voluntary consumption and pay a lot more sales tax but the fact remains that sales taxes on mandatory spending hit the discretionary spending of the poor far harder than they do the rich. Furthermore the rich will generally invest in things that generate future value, like stocks, and amazingly there is a sales tax on the loaf of bread that the poor literally have to buy but no sales tax on the stocks that the rich choose to buy to become richer.
There is a very worrying trend of states lowering their income taxes and trying to replace them with sales taxes which is tantamount to class warfare. And you need to tax the poor far more heavily than you do the rich to get the same amount of money back because the poor don't have as much to give. Fuck sales taxes basically.
Long term capital gains taxes work on a flat bracket system based upon your AGI. You do not pay income tax on LTCG because it is not income but which income tax bracket it would be in is still important. How it works is you add your LTCG and your AGI together and see which tax brackets it would fall into, assuming AGI comes first. The two important sets of brackets can be seen here.
+ Show Spoiler [filing single] +![[image loading]](http://blogs-images.forbes.com/kellyphillipserb/files/2014/10/Single_rates.png)
+ Show Spoiler [MFJ] +![[image loading]](http://blogs-images.forbes.com/kellyphillipserb/files/2014/10/MFJ_old.png)
So, if your AGI was $20,000 and you were filing alone with $10,000 of LTCG then $9,225 of your AGI would be in the 10% bracket, $10,775 of your AGI would be in the 15% bracket and all $10,000 of your LTCG would be in the 15% bracket.
However if your AGI was $30,000 then $9,225 of your AGI would be in the 10% bracket, $20,775 of your AGI would be in the 15% bracket but only $7,450 of your LTCG would be in the 15% bracket, with the other $2,550 being in the 25% bracket.
And this is when it gets important because LTCG is taxed at different rates depending upon where that $ would fall if it were income.
All LTCG that would be taxed at 15% or lower if they were regular income are taxed at 0%.
LTCG that would be taxed at 35% or lower if they were regular income are taxed at 15%.
LTCG that would be taxed at 39.6% if it were regular income (so over $400,000 or so) are taxed at 20%.
What this means for our earlier situation with $30k income and $10k LTCG is that $7,450 of his LTCG are in the 15% bracket and therefore tax free while $2,550 are in the 25% bracket and therefore taxed at 15%. Hopefully that makes sense.
The United States Federal Income Taxes work on a progressive system like those of most of the world with a series of increasing percentage bracket. Everything you earn up to the 9,225th dollar is taxed at 10%, the 9,226th dollar is taxed at 15% without in any way impacting the tax of the first 9,225. The way this system works is that an increase in taxable income does not, and can not, decrease your post tax income. The stepped nature of it also works well to protect necessary income to survive. If we assume that a human must first buy food, water, shelter and so forth then having an amount of money that would cover those barely taxed is pretty reasonable. Everyone needs those things so the money that covers them is at 0% to 10%. Car payments, eating out, that kind of stuff is 10% to 15%, vacations nearer 25% and so forth. The very first $10,300 you earn isn't covered by any of those brackets as it is not taxable income so slips by at 0%.
While it is possible that a pay increase could result in your AGI disqualifying you for a big tax credit or benefit, so a pay raise could result in you being poorer (although not due to the progressive income tax structure) putting that pay raise into retirement funds, a FSA or a number of other options would protect your AGI.
However, in addition to Federal Income Taxes there are also a lot of states with sales taxes at a fixed percentage. This seems, on the face of it, a flat tax but in practice it is very regressive because it is a tax on consumption and consumption is often involuntary and uneven across income classes. Let's assume that it costs $20,000 of consumables (rent/gas/food/utilities) for a family to survive. If your family earns $30,000 and there is a 10% sales tax then you're paying $2,000 on top of your $20,000 just to survive. Taxes have taken 20% of your discretionary income of $10k and 6.7% of your gross. A richer family that earns $70,000 a year spend the same $20,000 on forced consumption with $2,000 tax. For them that same $2,000 represents a 4% tax on their discretionary income and a 2.8% tax on their gross. Now they may go on to spend every remaining dollar they have on voluntary consumption and pay a lot more sales tax but the fact remains that sales taxes on mandatory spending hit the discretionary spending of the poor far harder than they do the rich. Furthermore the rich will generally invest in things that generate future value, like stocks, and amazingly there is a sales tax on the loaf of bread that the poor literally have to buy but no sales tax on the stocks that the rich choose to buy to become richer.
There is a very worrying trend of states lowering their income taxes and trying to replace them with sales taxes which is tantamount to class warfare. And you need to tax the poor far more heavily than you do the rich to get the same amount of money back because the poor don't have as much to give. Fuck sales taxes basically.
Long term capital gains taxes work on a flat bracket system based upon your AGI. You do not pay income tax on LTCG because it is not income but which income tax bracket it would be in is still important. How it works is you add your LTCG and your AGI together and see which tax brackets it would fall into, assuming AGI comes first. The two important sets of brackets can be seen here.
+ Show Spoiler [filing single] +
+ Show Spoiler [MFJ] +
So, if your AGI was $20,000 and you were filing alone with $10,000 of LTCG then $9,225 of your AGI would be in the 10% bracket, $10,775 of your AGI would be in the 15% bracket and all $10,000 of your LTCG would be in the 15% bracket.
However if your AGI was $30,000 then $9,225 of your AGI would be in the 10% bracket, $20,775 of your AGI would be in the 15% bracket but only $7,450 of your LTCG would be in the 15% bracket, with the other $2,550 being in the 25% bracket.
And this is when it gets important because LTCG is taxed at different rates depending upon where that $ would fall if it were income.
All LTCG that would be taxed at 15% or lower if they were regular income are taxed at 0%.
LTCG that would be taxed at 35% or lower if they were regular income are taxed at 15%.
LTCG that would be taxed at 39.6% if it were regular income (so over $400,000 or so) are taxed at 20%.
What this means for our earlier situation with $30k income and $10k LTCG is that $7,450 of his LTCG are in the 15% bracket and therefore tax free while $2,550 are in the 25% bracket and therefore taxed at 15%. Hopefully that makes sense.
Income taxes are progressive because fuck the rich/that's literally the only way we can make this work.
Sales taxes are regressive because, quite literally, fuck the poor.
LTCG taxes are progressive but also very low and available mainly to the rich. So basically fuck the proles.
So, that's how taxes work, in general. However you'll need to know a few things before you can really play the game and the most important of them is your AGI. AGI is Adjusted Gross Income, your Gross Income (how much you make) minus all the things that you can buy with pretax dollars (retirement savings, health insurance, FSA contributions, daycare and so forth). Your AGI is not your net (which is generally AGI minus taxes), it's how much you make before anyone has taxed you but after all your pretax contributions are made.
How to calculate tax
For the vast majority of lower to middle income American families the tax man is actually not trying to fuck you. There are a few key behaviours he'd like to incentivise you to do, such as saving for your retirement, going back to school or having kids (which has a shitton of costs but it will lower your taxes) and if you play ball then you pretty much don't have to pay tax. I've modified a very smart excel sheet to be more user friendly so it can work as a rough tax estimator (with EITC, child tax credits and Saver's Credits built in). No credit to me, I didn't build it, and obviously it's not a infallible source.
https://docs.google.com/spreadsheets/d/1La07JcvKTk-MfQTE_r-hlEipHv_oDm3TSbDo1oZhiPM/edit?usp=sharing
Put your best estimates of numbers in column B and then tell it how you're filing etc in the green squares and it'll tell you, to the dollar, what you should owe.
The beauty of this approach is that it brings the taxes under your control. Rather than shit just happening and then you finding out how much you owe you can choose how much you want to owe and then modify the shit that happens to create that result. It quickly becomes clear that planning can have a huge impact and that failing to plan can have an equally huge impact.
An example that I ran into personally was with 401k contributions when my AGI was near $36,000 (cutoff for the 50% match when married filing jointly). Reducing my 401k contributions by $1000 a year would increase the amount that I was able to spend that year by $170. The other $830 was lost in increased taxes. With this in mind I can make sure that I know how much to contribute in order to get the AGI to where I need it. Pretty much all benefits are decided by AGI so knowing where it comes from and how to manipulate it is pretty important.
AGI is most easily manipulated by retirement savings. While obviously it sounds like it sucks to save for retirement you don't have to leave the money in there until retirement, as my last blog explained, and there are certainly worse problems to have than a shitton of money compounding away in investment accounts.
So, by this point we've worked out how much tax we'd like to pay this year. Hopefully it's a low number, bonus points if you can get it in the negatives so that your tax refund really is free money from Uncle Sam. Now it's time to fill out a W-4 to let them know how much to withhold for Federal taxes. You see you don't actually pay taxes at the end of the year, they don't trust us to save up the money and be ready for it. Instead take a very generous estimate of how much you could owe out of every paycheck and then give you back what is left over at the end of the year. For most people this leaves them missing a lot of money they could put to excellent use for most of the year but for people playing with retirement contributions it's even more devastating for three reasons.
- We're overpaying by far more than most people because we don't owe any tax.
- We're making our actual post-tax spending money so low through payroll contributions that we need every dollar we get and can't afford to have money tied up.
- We're actively investing, loaning Uncle Sam money for a year interest free has opportunity cost.
What I've done this year is worked out what I'll owe, added a little just to be safe, and then let them take taxes out of my paychecks until it hit that amount. Then I filled out a W-4, wrote exempt on it and no more taxes for me this year. It's not optimal but it works for me and protects me against overpaying.
The big tax credits to be aware of are the Saver's Credit, the EITC, child tax credits and the educational ones. Tax credits can be refundable or non refundable (or partly refundable) which can be confusing. A refundable tax credit isn't a tax credit at all, it doesn't decrease your taxes or come out of your taxes or anything like that, it's just money they give you at tax time. The EITC works like that. You could owe $0 in taxes and they'd still give you a refund for it. Refundable is the best type. Non refundable credits are actually tax credits, you can use them to cancel out parts of your tax obligation so you can, with enough of them, reduce your tax obligation to $0 but you can't get them to give you any money back. Non refundable credits apply before refundable which is awesome because it means you can use them in combination. One fun feature of non refundable credits is "shit, we didn't pay enough in tax". That feeling when you can cancel out $2,000 in taxes but you only actually paid $1,500 so you have to call up your broker and see if he can come up with $500 of capital gains for you to lock in for this tax year.
Long term capital gains are taxed separately at a rate that varies depending upon how much you have, as I understand it. However they still form part of your AGI. They are only taxed at the time of selling, stocks that appreciate or a house going up in value don't mean anything until it is sold and those gains are locked in. At that time the difference between the buy value and the sell value is used. Choosing when to sell can be useful for tax purposes, particularly with stocks. If you have excess non refundable credits then taking the tax hit this year rather than next can be appealing. Or if one company in your portfolio has done very badly but your regular income was unusually high this year then selling could lock in those losses, reducing your overall income and saving you some income tax. You can buy back the stocks, although not immediately (although workarounds exist).
The variable rate is pretty huge because while they do increase your AGI there is a 0% tax bracket on the first $72,000 or so of capital gains in any given tax year (when MFJ). What this means is that a family of two adults with no children could conceivably have an earned income of $20,600 and a capital gains income of $72,000 for an AGI of $92,600 and pay 0% tax without the use of a single credit. 'murica.
+ Show Spoiler [Your effective tax rate] +
If you take your taxes and divide them by your AGI you'll get what percentage of each dollar you're paying in taxes. While some dollars will be taxed at 0% (first $10,300 for example) and others at 25% (or whatever) they're all grouped together so you will have an effective tax rate. This can be pretty confusing when trying to work out how your taxes work in the case of bonuses, raises and other unexpected money.
The IRS will estimate your AGI and then work out your effective tax rate, as you have just done. Rather than say that you owe nothing on the first dollar and 25% on the fifty thousandth dollar they put them all together and take an amount out of each. But if they have to revise their estimate of your AGI then that'll change your entire effective tax rate for the year, including the paychecks in the past. If they were taking 5% out of each paycheck to cover your taxes but it turned out that, due to your huge Christmas bonus, they should have been taking 6% out then they can't exactly go back in time and take more out of each. So instead your bonus doesn't get grouped with the rest of your pay, it gets its own group on top of the rest of your pay. Dollars one to fifty thousand are already accounted for in terms of taxation so the bonus dollars aren't grouped with them but instead form a group at $50,001 and up. This group will have its own effective tax rate which will be much, much higher than the one of the first group because they're all in higher brackets.
At the end of the year it'll all work out of course. You were undertaxed on the first $50,000 because it assumed that you were only earning $50,000 so your effective tax rate on that block was too low. And then you were overtaxed on the block above $50,000 to compensate for that. That's how the phenomenon of "I swear my bonuses are taxed at a different rate than my regular pay" comes about. It's true, but not meaningfully true, just a feature of how they revise their estimates.
It's important to understand that most taxes are, effectively, consumption taxes. Money can be kept in a pretax form where it is whole, virginal and ripe for investing but pretax money can very rarely be spent on consumption (some healthcare/daycare exceptions apply). However if you want to enjoy your money then it must be converted to post-tax and you must pay income taxes on it. With this in mind the reality of the situation is that your Starbucks coffee doesn't cost you $4, it costs you $5 of pretax money. If you hadn't needed that coffee you could have contributed a little more to a tax deferring account and not paid tax on that money. This is especially true for the working poor for whom there are a large number of credits and benefits available dependent upon their AGI. It comes down to my example right at the top, where increasing the available spending money by $170 increased the taxes paid by $830. Consumption is your enemy, run the numbers first and find out how much you can afford. If you must consume then you want to run that shit through LTCG first, if you're working poor like me then an investment income of up to $72,000 sounds like more than enough and you can get that at 0% tax.
TLDR:
Find out what you'll owe in advance.
See if playing with it will have awesome results.
Fix your withholding.
Stop paying tax.
This post was done at night with thoughts being pretty disorganized and without notes. It'll need cleaning up in the morning. Sorry in advance.
plus, if corporations get to benefit from the casualization of labor, so should I!!!
