How Do Taxes Work

Hey what's up everyone and welcome to the School of Personal Finance. So nobody likes to pay more income taxes than they need to and the first step in accomplishing this is understanding how our tax system works. So in this video I'm going to walk you through a very simple example of how we pay taxes in this country. Let's get to it. So you know our tax code it really is just a system of incentives. So the government they pretty much lay out what they want you to be doing in order to pay less taxes. So for example if you own a very large corporation and you employ a lot of people you pay less in taxes. If you are a developer and you provide housing to many people you pay less in taxes. Unfortunately it is the everyday hard-working people who have w-2 salaried positions that have very little wiggle room and very little opportunity to pay less in taxes. So how do income taxes work? Let's start with our simple example. Let's say we have a married couple three children they both have salaried jobs w-2 incomes they make $75,000 each. So all together they make 150 grand. Some people who don't really know might just assume that they pay 22% on all of that income. Because if you look at our tax brackets making $150,000 would put you in the 22% tax bracket. So you might think to yourself well just take $150,000 22% of that that's how much taxes you would owe for the year. But that is not at all how our tax system works. So for this example let's make the assumption that they are contributing to their 401k plans. So now 401ks they come right off the top. So if they contribute in this example $25,600 to their 401ks that means that they're left with w-2 wages of $124,400 that's what their w-2 forms would add up to. And now once we take that that would be line one of their 1040 on their tax returns. Now after that they would have any other additional income that they would have to report. So like if you're self-employed or if you have capital gains any other income rental income all those things would have to be reported and they would get added to the w-2 income. We're not going to use anything in this example. And then you would also have adjustments to income things that could be subtracted from your income. So it would be like student loan interest or if you made an HSA contribution. If you have a high deductible health plan and you contribute to a health savings account or if you're eligible for a traditional IRA deduction that would be subtracted from your income. In this example we're going to have zero for that so no adjustments to income. And that'll bring us down to our AGI our Adjusted Gross Income. In this example it's going to be the $124,400. And now once we get to this point then we have either the standard deduction or we can itemize our deductions. And we get to choose based on which one is more advantageous to us. So for 2019 the standard deduction is $24,400. So in this example it makes the numbers work out very nice. So after the standard deduction this couple is left with a hundred thousand dollars of taxable income. Now a lot of people make the assumption that if your taxable income is a hundred thousand dollars that you have to pay 22% of that because you are in the 22% tax bracket there. So you'd owe 22,000 bucks and call it a day and that's it. But that's not how our tax brackets work. We have what's called a progressive tax system. So if we look at the tax brackets the easiest way for me to explain this is that the money inside of each bracket gets taxed at that bracket's rate. So if we look at the first bracket $19,400 of your income is going to be taxed at that 10% rate. So that's $1,940 bucks. Then the income over that is going to get taxed at the 12% rate up to $78,950. So that would be $7,146 worth of tax. That's 12% of the amount that you've earned above $19,400 and below $78,951. So all the money in that 12% tax bracket gets taxed at 12%. And then if you still have more income we move down into the 22% tax bracket. So all these dollars are going to get taxed at 22% all the way up to $168,400. And now we just add up the amounts from each bracket that you would owe in taxes and that's how we get your total tax liability. So if you're in the 22% income tax bracket that does not mean that all of your income is taxed at 22%. That's why we call this a progressive tax system because the first $19,400 is only taxed at 10%. Up to the next $78,950 it's only taxed at 12%. And so on and so on and so on. So if you are in the 37% tax bracket that does not mean that all of your money was taxed at 37%. You were subject to each of these brackets going through progressively. And that's how our tax system works. So you add up the amount of tax liability for each bracket and that's how we get the total amount of taxes that you owe. And now this is before we get to any credits that you might have available to you like the child credit which is now increased from $1,000 to $2,000 for each child that you have. So that is an amazing credit. Me having three children I was able to get a $6,000 credit against my tax liability for 2018 because I had three children. So that is that is a very nice credit to have and they raise the income limitations on that so that it applies to a large majority of people out there. So a tax credit is much more valuable than a tax deduction. So for this very basic plain vanilla example they would owe $7,717 for taxes for the year. But now both of them are W-2 employees so they were having federal taxes withheld from their paychecks every year. So this is where we get into tax refunds. Now some people confuse tax refunds with actually how much you're paying in taxes but it really doesn't matter. What they owe in taxes is this $7,717. But if they had $17,717 withheld from their paychecks throughout the year then they would get a refund of $10,000 back. If they chose to only have $4,717 withheld from their paychecks all year then they would owe an additional $3,000 in taxes at tax time. So the amount of your refund or the amount that you owe every year just depends on how much you're actually having withheld compared to how much tax you actually owe. So again in this example the amount that they owe is not changing. They owe that amount no matter what. What they have control over is how much is actually withheld from their paychecks every two weeks or however often they get paid. So if they choose to have a large amount of money withheld from their paychecks every year then obviously they're getting less money every paycheck because more of it is being withheld. But they're going to get a larger refund back where if instead if they choose to have a very small amount withheld then they might end up owing money at tax time. But the actual tax liability this $7,717 that is not impacted by the amount of their withholding. They owe that money no matter what. It's just a matter of if they have more or less withheld throughout the year that's going to directly impact the amount of their refund or the amount that they owe when tax time comes. And the biggest takeaway that I want you to understand is that you pay less taxes when you are a large business owner that is selling stock because of capital gains or if you are a professional investor. If you are investing in large apartment complexes or rental real estate or large businesses stocks all of that stuff it is taxed at lower rates. That is why Warren Buffett famously pays a lower tax rate on his income than his secretary does. Because Warren Buffett is an investor. He is paying capital gains rates where his secretary earns ordinary income and she is going against these brackets. She is paying ordinary income tax rates on the money that she earns. And when you are a W-2 employee there is very little room for you to reduce your taxable income. You could max out 401ks. You could contribute to IRAs if you're eligible for the deduction. You could contribute to HSA accounts if you're eligible for if you have a high deductible health plan. Other than that there's not many ways to reduce your taxable income each year. Alright that's it for this one. Hopefully that was easy to follow along and you learned something from this. If you did please hit that like button. Please subscribe to my YouTube channel if you have not done so already. I will see you again in the next video. Take care.