How Do Federal Income Taxes Work? (Part 2 of 3)

Welcome to Part 2 of 3 in my series to try to simplify the concept of federal income taxes. I hope you stick with this series, I’ve tried to lay it out in a way that I wish it were laid out for me 10 years ago. In Part 1, we learned how to calculate your “Taxable Income”. This is basically how you take how much total money you made in the year and reduce it down to the number that the IRS says you need to pay taxes on.

So now you’re ready to go to the “tax tables”. But the tax tables are really a massive table of calculations. I think it’s easier (and of more value for understanding taxes and thinking about ways to reduce your taxes in the future) to calculate it yourself. So instead we’ll use the tax brackets. Here are the tax brackets for 2014 for a married couple, to continue with our example:

Click here for tax brackets and other good 2014 tax details

Don’t worry, it’s not as complicated as it looks. We just calculated your (theoretical) Taxable Income of $30,300 in Part 1. The left side of the chart gives all of the ranges of income possible, we’re in the 2nd row down, between $18,150 and $73,800. So, the first $18,150 of EVERYBODY’S taxable income goes into a bucket that’s taxed at 10% (blue piece  in chart below). The next piece of your pie of taxable income gets taxed at 15% (red). (In our example, this is the highest amount our money is taxed at. Some people get a portion of their money taxed at 25%, another portion at 28%, etc. But everybody gets the first portion taxed at 10%, next at 15%, and so on.

So our taxable income of $30,300 turns into:

$1815 ($18,150 X 10%)

+   $1823 ($12,150 X 15%)

=   $3638

Ok, so the government says with your income and your personal situation with regards to your family and how you spend your money, you owe them $3638 in federal income taxes for the year.

But wait, there’s more! Note that for all of the deductions and exemptions, you’re reducing the amount of taxable income you have. In the end, you’re going to have some money falling into those brackets and the government is going to take their slice of your pie. BUT, at this point there is a way to reduce the taxes that you owe more quickly than reducing your taxable income: Tax Credits. These are not applied up front, but rather after you determine your taxes owed, they directly reduce what you owe. The most common and well known tax credit is the child tax credit. Basically, this is $1000 per kid 16 and under (this amount can be reduced depending on your income). Some other common credits: education credits (paying college tuition, for example), energy credits (put in geothermal, for example), retirement savings credits (if your AGI is under $60k and you’re putting money into retirement accounts), and child care credits (day care, for example).

That’s a lot of stuff, but the big picture is that once you calculate your taxes based on your income, you look for these credits and start subtracting. Since this family has a 2 year old and a 4 year old:

$3638 taxes owed

– $1000 X 2 children

= $1638 is the total amount that the federal government asks you to pay for the year. That’s it. We made it. You made $67,500 in your family and the government says that you need to share $1638 of that.

Summary

Ok, that was the big picture. Now I’m going to simplify it down to just the math and basic description.

Recap

$67,500 how much money you made

–  $3500 put into Traditional 401k retirement

–  $5500 is withdrawn for health insurance premiums and HSA

=  $58,500 Adjusted Gross Income (AGI)

–  $15,800 family of 4 exemptions X $3950

–  $12,400 standard deduction for married couples

=    $30,300 Taxable Income

Drop your Taxable Income into the appropriate buckets, first $18,150 in the 10%, the rest in 15%.

$1815 10% bucket

+    $1823 15% bucket

=    $3638 Taxes

–     $2000 Child tax credit

=    $1638 Owed to the IRS for Federal Income Taxes in 2014

OH NO! You mean I have to write a check for $1638 to the government?!? This is a disaster, Joel, my tax preparer works the numbers so that I get a check sent to me! Hold on there. The 3rd and final installment of this riveting series will bring it all together. It will include a little less math and a little more explanation, which I’m guessing you’re thankful for.

Stay tuned for Part 3 of 3!!!

-Joel

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