Reduce Your Tax Bill - Understanding Income Tax

Hey, what's up, everyone, and welcome to the School of Personal Finance. So we would all like to reduce our tax bill. Nobody wants to pay more in income taxes than we are legally required to do. But the tax code, it is complicated. So the first step to being able to reduce your taxes is to educate yourself, to have the basic understanding of how to even come up with the calculation of how much tax we owe. So in this video, I'm going to walk you through a very basic, simple example just to build that foundation, just so you understand exactly how they are actually calculating how much taxes you owe. So then you can make decisions around how could I actually reduce this number? What actions could I take to reduce the amount of taxes that I have to pay each year? All right, let's get to it. All right, so just real quick, head over to schoolofpersonalfinance.com, get on my email list, check out the power sessions that I'm offering now where we could work one-on-one. And also, if you find value in this video, don't forget to hit that like button. It helps so much pushing it out to more and more people on YouTube and helping me grow the channel. All right, so the last thing I want to do in this video is get in the weeds on taxes. So now I'm not a CPA, full disclosure, I'm not giving anybody tax advice here. I just want to walk you through a very simple example so you can understand some very important components that go into calculating how much tax you owe each and every year. So we're going to touch on deductions versus credits. I'm going to walk you through a very, very simple example so you could hear me talk my way through it so you understand exactly how it all works. So let's jump into Red Capital and I'll walk you through a simple example. All right, so we have Frankie and Lucy. They are a married couple. They have two kids. Frankie's making $100,000 a year, and Lucy, who works part-time and she's a part-time stay-at-home mom, she's making $30,000 a year. So now they are married, filing jointly, and they both work for employers. So they are W-2 salaried employees and they're making $130,000 a year between the two of them. Now if we go over and we look at what their tax return might look like, and now this is like a condensed version of the tax return of the 1040 form. So these numbers over here, like the lines, they're not going to coincide with the tax form that you might be using. But let's start right at the top. If we look at line number one. So we can see their W-2 income is $115,000, all right? So now the reason that it's only $115,000 is because they are saving in their 401k plans. So Frankie, he is saving $10,000 in his 401k, and Lucy is saving $5,000. So between them, that is $15,000. So that's why this number is $115,000 compared to the $130,000 that their salary is. So that is the first important point. When you contribute to your 401k, to the traditional 401k, it is deducted right off the top. It doesn't even show up. That income does not even show up on your W-2 forms. So when you go to fill out your 1040 and you're putting in the amount for your W-2, that contribution to your 401k, it's as if it doesn't exist, right? That income, it's already gone. They've already taken it off the top. So you are saving on federal taxes for any dollar amount that you contribute into your 401k. So now these next few lines here, this would be if you have interest, like you have money in a bank account that you're earning interest on, if you have any dividends, if you've taken any money out of IRAs or pensions or annuities. So what we're trying to get to here is your total amount of income. So in their case, they only have $130 of interest included with their $115,000 of salary. So their adjusted gross income is $115,130. So adding up all your income and figuring that out, that's the first part to your tax return, right? The IRS wants to know how much income did you have for the year? Now after that, what we have is what's called either the standard deduction or an itemized deduction. So everybody gets a standard deduction. And what that means, it's just a dollar amount that you are able to deduct from your income that you don't have to pay taxes on. So in this example, they are married filing jointly. And for 2022, the standard deduction was just increased. It's $25,900. So that's $25,900 that they will not have to pay any income taxes on. So now what we do is we take the adjusted gross income and we subtract the standard deduction. And this is where we would get that $89,230. This is their taxable income. So this is the income that is subject to the tax brackets that they're going to have to pay taxes on. Now there are people out there who might have more deductions available to them that are higher than the standard deduction. So in those cases, then you do what's called itemizing your deductions. But in this case, we're not doing that. So for them, their taxable income, $89,230. So now what we're going to do is we're going to quickly go over and look at the actual tax brackets and how that works. All right, so these are the 2022 federal income tax rates. Now even though there's a lot of data on here, I'm going to break it down for you. So it's very simple. So if we focus on the left hand side, these are the different tax brackets, right? So 10%, 12%, 22% and so on. So now we're going to focus on married filing jointly because that's what we're using in this example. So if we look at the green over to the right here, married filing jointly. So now our tax code, it is a progressive tax system. So what that means is that, for example, the 10% tax rate, any taxable income between zero to $20,550, you are taxed at 10% on that dollar amount. So even if you make $1 million a year, your first $20,550 is going to be taxed at 10%. And then the income above that, the $20,551 all the way up to $83,550 is going to be taxed at 12% and so on and so on. So let's say you're making the big bucks and you're making like $10 million a year. You would be in the 37% tax bracket, which is the highest tax bracket. But still your first $647,850 worth of taxable income would be taxed at these lower brackets. And then every dollar over that would then be taxed at the 37% tax rate. So for Frankie and Lucy, their taxable income is $89,230. So that puts them in the 22% marginal tax rate. But that doesn't mean that they pay 22% on all of that taxable income. It's actually only on a very small amount. It's anything over $83,550 that they are paying that 22% on. Everything below the $83,550, they're paying 12% or 10%. It's 10% up to that $20,550. And then for all the money in between that $20,551 to $83,550, they're paying 12% on that. So then once we do the calculation of adding up how much tax they owe in each of these brackets, we would come to the final number, $10,865 would be the amount of tax that would be due. But we're not done yet. So next we have some tax credits that are available. So now tax credits are great. They reduce the amount of tax you owe on a dollar-for-dollar basis. They are very powerful. So the biggest tax credit that we're all probably familiar with, especially if you have children, is the child tax credit, where in 2022, you are going to get $2,000 for each qualifying child that you have, each dependent that you have. So $2,000 tax credit, in this case they have two children, so that is $4,000. So that directly reduces the amount of tax that they owe dollar-for-dollar. So instead of them owing this $10,865, we subtract out the $4,000 in child tax credits, and their amount of tax that they would owe is $6,865. And then that would be it. So now we said that they're in the 22% marginal tax bracket, right? But again, that doesn't mean that all their money is taxed at 22%. So another term is what's called your effective tax rate. And to get that rate, what we do is we take the amount of tax that you owe, and we divide it into your income. So in this example, they have to pay $6,865, and their income for the year was $115,000. So that is only a 6% effective tax rate, right? They're really only paying 6% of their income in federal taxes, and we aren't even touching on state taxes, because all the states are different. So I'm not going to go down that road. But in this case, 6% effective tax rate for their federal income taxes, which really is not bad, even though they're in a 22% marginal tax bracket. So next thing I want to do real quick is just show you what I would recommend, if these were my clients, what I would recommend that they do to reduce that tax bill even a little bit more. So now their taxable income is the $89,230. And remember, the top of that 12% tax bracket is $83,550. So anything over that $83,550, they are now paying 22% on that. So one very simple recommendation that I would have for them, if they were able to swing it, would be to just increase their 401k contributions to bring their income down back into that 12% tax bracket. For every dollar that they contribute into their 401k, that they reduce their taxable income, they are saving 22%. So what they could do is they could just funnel that money into their 401k and save 22% on that amount. So in this case, it would be about $5,700 that they would have to increase their 401k contributions to then bring them back down into that 12% tax bracket. So now obviously they would have less money in their pocket because they're putting more money into their 401k for retirement, but they would save about $1,250 in taxes by doing so. So if they were my client, I would definitely recommend that they do that and take advantage of putting that money in the 401k and reducing their tax bill and bringing them down below that 22% tax bracket. And then at that point, if they said to me, you know what, I could even save more than that, then I would recommend that they go and they contribute to Roth IRAs instead of continuing into their 401k because now with their 401k and the additional money they save above and beyond that, they would only be saving 12% in taxes by doing that because now they would be bringing themselves even further down into that 12% tax bracket. So instead of doing that, I would much rather see them forego the tax break and the additional tax breaks and instead contribute to a Roth IRA where they don't get the deduction now, but then that money will grow tax-free forever. So it's just a very simple strategy to bring their taxable income down to the top of the lower tax bracket and then go into the Roth IRA or even the Roth 401k. If that is an option for them at work. All right, everyone. That is it for this one. I hope that you found it helpful. I am kicking around the idea of creating an entire elective course all about taxes and strategies around that in the Education Center at School of Personal Finance. So go make sure to check that out. I will see you again in the next video. Thanks a lot. Bye.