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#19 How Do Taxes Actually Work?

#19 How Do Taxes Actually Work?

May 12, 2023

There's often a lot of confusion when people hear tax terms thrown out like deductions, credits, Adjusted Gross Income and more.

In the lead up to the tax filing deadline, we give you a breakdown of how the federal tax system actually works, so you have the tools you need to know to make it work for you!


2022 Federal Tax Brackets 


Tax time is upon us, and many of you are reading articles about how this year's tax refund may be a little lighter than it's been in years past. So in this episode, we're gonna do a quick primer on how taxes work in the first place and introduce you to some key elements that will impact what that return might be.
Let's get started.
Hello, my name is Brenton Harrison of New Money, new Problems, and your host for the New Money New Problems podcast. It is March of 2023, and we are about a month out from the April 15th tax deadline. And if you're like me, you're gathering up those tax documents, you're sending them into your tax prepare, or you may be uploading them to TurboTax and clicking through that tax software, and you're hoping that in some cases when you get to the end of that software, you're gonna see a tax refund that's bigger than you expected, or in my case, in the case of many others, you might be hoping that your tax preparer will email you back letting you know that you owe less than you were expecting from the previous tax year.
But in that process, I would say that the [00:01:00] majority of people are waiting for that email or clicking through that software without a lot of understanding about what's going on behind the scenes as it relates to how taxes work. and when we're at parties or when we're talking to coworkers and we hear them complaining about taxes, oh,
I'm in the 32%, 35%, 37% tax bracket. We might be led to believe that it means they're paying 32, 35, 30 7 cents on the dollar for every dollar that they earn. But that's not how taxes in this country work. It would be if we lived in what's called a flat tax rate environment. If you had a person who earned a hundred thousand dollars and that put them in the 24% tax bracket, a flat tax would say that they owe 24 cents on every dollar that they earn.
In the United States, however, we live in a progressive tax environment, and that means that lower portions of your income are taxed at lower percentages, and as your income progresses, so does the percentage of [00:02:00] tax that you pay on that portion of your taxable income.
In this episode, we're gonna use the example multiple times of a single person who has a hundred thousand dollars in taxable income, and there's a reason that I'm putting emphasis on taxable income as compared to saying income. If you're following along on the YouTube channel, you will see that we have the tax brackets pulled up for the tax year 2022.
Using our example of a single person earning a hundred thousand dollars of taxable income, you will see that no matter what a person earns the first $10,275 of their income is only taxed at 10%.
Everything from that level to $41,775 is taxed at 12%. Everything from that level, 41,770. To $89,075 is taxed at 22%, and if our example of John or Jane Doe earns a hundred thousand dollars of [00:03:00] taxable income, That actually places them in the 24% tax bracket because the 24% tax bracket encompasses everything from $89,076 all the way up to $170,050.
So while 24% is the tax bracket into which the highest portion of their income is falling, the lower percentages are actually encompassing the majority of their income.
As an example, at a hundred thousand dollars, you can see. That they only pay 24% on the portion between $89,076 up to a hundred thousand. So of that taxable income, only about $11,000 of it is going to be taxed at their highest tax bracket. Now, the difference between what they actually pay in taxes. When you total up all of those lower levels versus the bracket into which the highest portion of their income falls introduces two terms, and those terms are marginal tax [00:04:00] rate and effective tax rate. The marginal tax rate is the tax bracket into which the highest portion of their income falls. But your effective tax rate is the tax percentage that you actually paid when you total up all those lower levels. And it is often radically lower than your marginal tax rate. So when someone says they're in the 32% tax bracket, they may be accurate, but when you look at their tax return, you might find that their effective tax rate is 18%, 20%, or in some cases even lower, depending on some things that they file in their tax return.
So after the break, we'll tell you about some of those elements that can radically reduce the amount of taxes that a person pays, and we'll finally tell you why I am so insistent on showing you the difference between a person's total income versus their taxable income.
Before the break, we introduce you to your first real examples of tax terminology. But I also made a particular emphasis when saying the term taxable income, [00:05:00] because your taxable income is often radically different than the actual income that you earn throughout the year. So in this portion of the episode, we're gonna walk you through the example of a person who is actually using tax tools to reduce the amount of income on which they pay taxes. And along the way, hopefully demystify some of the terms that you hear when you see articles or news stories about taxes in the first place. The amount of income that a person actually earns before they file their taxes is called their gross income.
But almost none of us will pay taxes or have the tax brackets applied to your gross income . The reason for this is because after you've totaled up your gross income, there are a number of tax tools that you can use to reduce the amount on which you actually pay taxes.
The first tool is called an above the line tax deduction. So first we have to define what a tax deduction is, and then we have to specify what an above the line tax deduction is. [00:06:00] A tax deduction, which is something that I'm sure you've heard of but not quite understood, is something that you can use to reduce the amount of income on which you pay taxes.
In our example of a person who earns a hundred thousand dollars, if they had a $5,000 tax deduction, the amount of income on which they pay taxes would be reduced from that a hundred thousand down to $95,000.
So in summary, a tax deduction takes your income from one level and reduces it before tax brackets are applied.
An above the line tax deduction then is an deduction that you can use regardless of how you choose to file your taxes, which will make more sense in a minute. But an above the line tax deduction is accessible to all of us.
They encompass things like the amount of money that you contribute to a pre-tax retirement account. In some cases, if you're an entrepreneur, you pay self-employment taxes and half of the self-employment taxes that you pay are also considered an above the line tax deduction.
Now, once you total up all your above the [00:07:00] line tax deductions and you deduct them from your gross income, you have arrived at another tax term and that tax term is adjusted gross income.
Once you've arrived at adjusted gross income, there is a major decision that has to be made, and that decision is, am I going to take another tax deduction that the I R S offers me no matter what, or am I going to go and find my own tax deductions instead? What I'm describing is the difference between doing something called itemizing your tax deductions or taking the standard tax deduction.
Again, if you're following along with us on screen, you will see that we're looking at an article that's talking about something called the standard tax deduction and the standard tax Deduction. Is a tool that the IRS allows you to use to further reduce the amount of income on which you pay taxes.
Again, everyone has access to a standard deduction. And in the tax year, 2022, for a person who was single or a person who was married, filing [00:08:00] separately from their spouse, that standard deduction was $12,950. So they are saying that in our example, we had a person who earned a hundred thousand dollars.
They had $5,000 of above the line tax deductions, which brought their adjusted gross income down to 95,000. If our person in our example, chose to take the standard deduction, they could deduct another $12,950 from their adjusted gross income, and that would leave them with a taxable income of $82,050.
We started with the person who earned a hundred thousand dollars and already we have used tax tools to bring their taxable income on which they will actually pay taxes all the way down to a little over $82,000. Over $17,000 of what they earned has been wiped off the table before the tax rates are even applied, but that's if they chose to take the standard tax deduction [00:09:00] of $12,950.
What if, however, they looked at some of the other tax deductions that they could use and decided that they were eligible for more than $12,950? Some of those tax deductions are things like charitable contributions. If you work for yourself, there are things like the amount of miles that you drive for business purposes throughout the year, or business expenses that you have throughout the year. And all of us have the ability to total up those expenses, those deductions for which we're eligible, and compare them to the standard deduction.
So let's say that our person in this scenario, Has access to $12,950 in the standard deduction. But when they total up the deductions for which they're eligible, they find that they actually have $20,000 of stuff that they did on their own that they could use to reduce that taxable income.
They would instead choose to take the higher amount, the $20,000, and if they do so, they're doing what's called itemizing [00:10:00] their taxes. They're listing out the deductions for which they're eligible. They're sending them in with their tax return to be verified by the I R S.
If you itemize, the deductions that you are using are different than the above the line tax deductions that we discussed right after the break. Everything that you use to itemize your taxes is what's called a below the line tax deduction, and they are things that everyone doesn't have access to.
You can only claim below the line deductions if you choose to itemize your taxes .
Once we've taken our gross income and we've subtracted our above the line tax deductions to come to our adjusted gross income, and then we've decided whether we're going to take the standard deduction or the itemized deductions, the number to which we arrive is our taxable income. This is the amount on which we will actually pay taxes.
So in our example, we had a person who had a hundred thousand dollars of. We subtracted $5,000 of above the line tax deductions, [00:11:00] and we found that they had $20,000 of itemized tax deductions, so they decided against the standard deduction and they claimed $20,000 of below the line itemized tax deductions.
All of that brought their taxable income down to $75,000. This is the amount that we're going to take to the tax brackets and see where we land.
Going back to our examples on screen, just because of the tax tools that we use, we have dropped ourself down an entire tax bracket. And now we find that everything from $41,776 to their $75,000 taxable income will be taxed at 22%.
Now for the sake of time, I've already done the calculations of what this means in terms of what they actually pay in taxes, and this would lead them to taxes of $12,117.
And this is a perfect example of the difference between your marginal tax rate and your effective tax [00:12:00] rate. Because even though this person made a hundred thousand dollars this year at $12,117 of taxes, if you compare it to what they actually made, they're only paying a little over 12% in taxes.
And even if we compare it to just their taxable income, they're paying a little over 16% in taxes. But we don't have to stop there. There is one more tax tool that we've yet to discuss, and that is what's called a tax credit. Whereas a tax deduction reduces the amount of income on which you pay taxes, a tax credit is a tool that reduces the taxes that you pay dollar for dollar.
As an example, when we discussed that $5,000 tax deduction that we used as an above the line deduction, it reduced our taxable income by that amount. But it doesn't mean that you saved $5,000 in taxes. At that point in time, the person in our example was subject to the 24% tax bracket.
So reducing their income by $5,000 saved them [00:13:00] 24% of that amount, a little over a thousand dollars. But a thousand dollars tax credit works very differently. If you have a thousand dollars tax credit, you are reducing the taxes you owe by a thousand dollars. To illustrate this, the person in our example has to pay $12,117 in federal taxes. We are going to assume that they have access to $2,000 worth of tax credits. Those credits reduce the amount of taxes they pay dollar for dollar from $12,117 down to $10,117.
So when you hear people talking about deductions and credits, a tax credit is more powerful than a tax deduction. And there are some credits that are what's called refundable credits, which means that you can get the full measure of that credit , even if it means that you pay no taxes and it becomes a tax refund, and there are some tax credits that are not refundable, meaning that the best that they can do is bring the [00:14:00] amount of taxes that you pay down to zero, but they cannot put you in a position where you get a refund of that credit.
Now that was a lot to cover, but I'm hoping that it was a good introduction to how taxes actually work and that it's demystified some of the terminology that you hear on the news and that you read in articles, because there have been a number of changes in this tax year that will radically impact whether you get a refund, how big that refund is.
Whether you owe, how much you owe, and in the next episode we're gonna go into the details of some of those changes. Apply it to the terminology we've learned in this episode so that you are more informed as to what's to come in this tax year. Talk to you soon.