Tax Time: No Fear Tax Year

Our favorite season is here! Tax season! By now, you should have received your W2 in the mail or have received an email about how to access it online. You might be excited about this time of year because you’re looking forward to a refund. Or, you could be dreading this season because you have no idea what you owe the government. If you are anything like I was up until a year ago, you have no clue how your taxes are calculated. You know there are these things called tax brackets and you’re supposed to pay a certain percentage of your income to the government. But that number never seems to match what you punch into the calculator. Then there’s the fun little fact that we actually pay three different governments: our local, our state, and the federal government. Knowing what to expect from your tax liability is a critical part of taking ownership over your finances. Even if you don’t save, you pay taxes. Even if you don’t invest, you pay taxes. Even if you don’t leverage your credit card for cash back or airline miles, you pay taxes. Everyone has to pay taxes and every piece of personal finance is touched by taxes in some way or another. Once you start to understand how taxes work, you can start to control how much you owe.

 

How a clerical error forced me to figure out the tax code

The previous two years I really looked forward to tax time because in my head it was refund time. My first year teaching, I got a refund of over $1300! I thought that was amazing. I thought I did something wrong when I typed everything in to Turbo Tax. But then, nothing happened. I got no notice that it was wrong. Other people seemed unsurprised by this number. So when year two rolled around, I had a little pep in my step as I prepared to do my taxes with trusty ol’ Turbo Tax. But my number wasn’t green in the corner. It was red. RED. I owed money!! I had to take $535 out of my savings to pay Uncle Sam! I was furious. I was outraged. I was terribly confused. I didn’t hit submit because I thought surely something was wrong. I’d ask someone else and I’d figure this out. People at work offered me the names of their CPAs and said, “don’t worry, they’ll figure it out. You don’t really owe that much.”

With the most perfect timing, a guest speaker came up on my course calendar. Someone from a free tax prep center was coming to teach my students about taxes. This is the one thing students always ask to learn about, even though it is something most adults never concern themselves with. She walked them (cough me cough) through how to fill out the federal tax form 1040 and showed the math on the board of what we were doing. I repeated the calculation for my own income. The reality sank in and I knew I had to pay the money to the federal government. There was no mistake. At least not in Turbo Tax. I hadn’t paid in enough throughout the year to cover my total tax liability. I set up the program to pay the money in at my next pay check, but I was still terribly confused. My mom asked me “what are your allowances set to?” “Uh, what?”

My problem was I had no idea how any of my taxes are calculated. People always said it was superbly complex and a normal person couldn’t understand it. My acceptance of this almost mystical calculation as something I couldn’t understand is why I, and so many of you, don’t know what to expect at tax time. When that guest speaker came in, I slowly began to understand how to calculate taxes. When my mom asked about my allowances, I added in another layer of understanding. When I logged into my employer’s management system for our time, pay, benefits, and career changes, I found that my allowances were set to 3, a number that usually only people with a dependent would choose. I would never write in “3” for my allowances. Single people always write “0” or “1” in that line. I changed that number to 0 and then saw a big difference in my check the next time I got paid.

Tax code is a multilayered subject that I believe everyone has the obligation to learn the basics of. While you can’t just not pay taxes, you can do things to set yourself up to optimize your taxes. That is, you can do things that are good for you that reduce your tax bill and spread your tax bill evenly throughout the year. Taxes are just like anything else in your budget: you must account for them and you can make choices that increase or decrease what you spend.

Components of the Tax Formula

The first thing you need to know is that your taxes are not calculated off of your gross income. I made $58533.73 in 2017. The government just doesn’t multiply that by a percentage and take it. I used to think that. It’s OK if you thought that too. There are a bunch of calculations to do first before they apply their percentage. The federal, state, and local governments use different percentages. These different calculations are why people think that taxes are so confusing, but I promise it’s all just arithmetic and you can figure it out with just a four function calculator. Before we go into a full on calculation, we need to just understand the background information first. My next article will take you through all of the steps to calculate your tax liability using my gross income. If you understand how to calculate your taxes you can make some amazing choices to budget and to build your wealth. My motto here is “knowledge is power.” You should not be afraid or confused by this financial certainty called taxes.

 

Gross Income

Fairly straight forward: the total amount of money you make before taxes. This would be the money you make from your employer, as listed on your W2, and any other income you received, such as interest or dividends on investments.

 

Adjustments

These are sometimes called “above the line deductions” and are items that are subtracted off of your Gross Income. Adjustments reduce the number that the government takes a percentage of in taxes. The adjustment many millennials use is the Student Loan Interest Deduction. The interest you are paying on your student loan each year helps reduce your tax liability. Your health insurance premium, health account contributions like HSA or FSA, and your retirement plan(s) are also adjustments to your income. Whatever their value, subtract from your gross income.

 

Adjusted Gross Income

After taking into account all of your adjustments, you arrive at a number called the Adjusted Gross Income (AGI). This is used to calculate your taxes! Well, almost. You still have to subtract off any additional deductions, exemptions, and credits. Those come next. But this number that you get for your federal taxes is needed for your state tax calculation.

 

Deductions

Now it is time to subtract off deductions. Just like adjustments, these are numbers subtracted from your income. So start with your AGI and keep subtracting. You will either go with what’s called “The Standard Deduction” or you will “itemize deductions.” People only itemize their deductions if it will benefit them more than taking the standard deduction. For tax year 2017, the standard deduction has a value of $6350. If deductions item by item add up to $6351 or more, a person should itemize.

Common deductions for itemization would be charitable contributions, mortgage interest, property taxes, state income taxes. You can also deduct sales tax you paid all year in lieu of deducting property and state income taxes. This would be a useful move if you bought something really big like a car. If you are a business owner, there are other deductions. But this post is just for Average Jane Millennial learning how to calculate her taxes. If Average Jane pays more than $6351 in charitable contributions, her mortgage interest and her state income taxes, then she will want to itemize her tax deductions. Otherwise she will just take the standard deduction.

 

Taxable Income

After subtracting off your adjustments and deductions, you have the value known as your “taxable income.” This is the value that the federal government is allowed to tax. You would then go to the tax bracket table for a single person, find where you land, and do the calculation. After a couple of operations, you find out your tax liability. This is what you owe, unless you have any credits to claim.

 

Credits

Credits are another way to reduce your tax bill for the year. Like deductions, they are values subtracted. But deductions are subtracted off of your income value before the percentage is taken. Credits are subtracted directly from your tax bill! This is better because you get a dollar for dollar reduction in amount owed. Common credits are the educational ones – American Opportunity Credit or the Lifetime Learning Credit – for those spending on higher education , the Saver’s Credit for those contributing to retirement accounts, earned income credit for those with moderate to low incomes, or the kid credits – the child tax credit, the adoption credit, and the child and dependent care credit – for those people with children. The best credits are of course the ones for people with children. Children save you money on your tax bill in order to offset the cost of raising them! The only credit I am able to claim is the Lifetime Learning Credit. I was able to subtract 20% of what I spent on summer classes at the local community college.

 

Allowances

After all of that subtracting and multiplying you did above, you know how much you owe to the government. If you figure this out for the year a head, you might be interested in making sure you pay the right amount into them throughout the year. You might want to pay too much in so you get a refund at tax time. Or you might want to pay too little so you owe in at tax time. There are pros and cons to each of these options. Allowances are what you allow for in your tax bill calculation. The higher the number you choose, the less you pay throughout the year from your paycheck. The lower number you choose, the more you pay in throughout the year. When I found out my allowances were set to 3, I was furious because it makes no sense for a single, child-less, non-retirement contributing person. I know I did not write 3. After discovering this error, I set it to 0 and started contributing to a retirement account so my tax liability would be reduced.

If you choose “0” that means you are not allowing for any deductions or credits. You will almost certainly get money back at tax time. Since everyone is able to chose the standard deduction, you can select 1 allowance and not have to owe any money at tax time. Higher numbers, 2 or more, are used if you have additional deductions or credits to account for. If you are single and pay enough into your health accounts and/or retirement accounts, 2 could be the right number for you. If you have a child, 2 could be the right number for you. For every child you have, you can up your allowances by 1 more.

 

Your Next Steps

Now you know what all these different terms mean. Gather all of the values of each on a piece of paper or in a Google Sheet. You can then calculate your total tax liability for the year. I will demonstrate how to do this in my next article. We will focus just on the federal tax liability. States have different calculations but follow the same mold. I promise that you can do this. I taught my freshmen this year how to calculate federal taxes and they even came up with the algebraic representation for each tax bracket, something I won’t ask you to do. If a 15 year old with no tax burden can do this, then certainly you can calculate it for yourself!

Once you are able to calculate your taxes on your own, you can start planning in ways to reduce your tax bill for the future. Tax planning can really enhance the control you have over your finances. This is by far my favorite financial calculation I learned this past year. I no longer wonder what will happen at tax time; I am in control of it.

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