You're paying way too much in taxes; Spend more time working for yourself
November 29th, 2020 by D.C. Poc
Taxes are a topic that very few people understand. I constantly hear the terms credit, deduction, and write-off, all intermingled in an incoherent way that is certain to signal a lack of tax code understanding. I can’t tell you how many times a married friend or co-worker has said, “man, this mortgage interest is really helping me on my taxes”, not understanding that they would need to deduct approximately $25k in said interest in order to change their tax situation (barring other large deductions). Fear not, I’m going to give you a 5-minute crash course on taxes, not by using fancy terms, or by quoting tax code, but by laying it out in numbers instead! With that said, I do need to give a few definitions to get you started.
Income: this is your gross annual pay prior to deductions.
Deduction: this is an allowable reduction to your income which, in turn, lowers your tax liability.
Credit: a direct reduction of tax liability.
Adjusted Gross Income (AGI): Income minus certain items (401(k) contributions, health premiums, etc.)
Non-Refundable Tax Credit: Can only reduce tax liability, cannot be refunded to taxpayer. This is applied prior to the refundable tax credits.
Refundable Tax Credit: Can be refunded to the taxpayer.
Compare these two examples:
New college graduate, making $50k a year, no mortgage, living in a state with no income tax.
401(k) Contributions: $19.5k
Health Ins: $2.4k
Std. Deduction: $12.4k
Taxable Income: $15.7k
The tax owed on the first $9,875 in income for a single-filer is 10%. So this is $987 The tax owed from $9,876 to $15,700 is 10%, which would be $699.
At this point, the individual would have a tax liability of $1686. Not bad!
Now, since they have an AGI (estimated) of less than $19,500 and contributed to a 401(k) plan, they will get a ‘Savers Credit’ of 50% of up to $2,000 in contributions. This would be a credit of $1k, which directly reduces tax liability.
The individual now owes $686 in tax. But wait… we’re not done. The individual may also qualify for the earned income credit (EIC) if their AGI is under $15,800 per year. This would be very close, but for the sake of our example let’s say they qualify. This is a credit of $538.
Total tax owed for 2020: $148
You read that right, you can make $50k a year as a single taxpayer and have a total tax liability of $148.50 for the entire year.
Married couple, 2 children, making $75k a year, mortgage, living in a state with no income tax.
401(k) Contributions: $19.5k
Health Ins: $5k
Std. Deduction: $24.8k
Taxable Income: $25.7k
The tax owed on the first $19,750 in income for married filing joint is 10%. So this is $1975 The tax owed from $19,751 to $25,700 is 12%, which would be $713.
At this point, the individual would have a tax liability of $2688. Not bad!
Now, since they file married-joint and have an AGI (estimated) of less than $39k and contributed to a 401(k) plan, they will get a ‘Savers Credit’ of 50% of up to $4,000 in contributions. This would be a non-refundable credit of $2k, which directly reduces tax liability.
The couple now owes $688 in tax. But wait… we’re not done.
The individual also qualified for the earned income tax credit (EITC) due to their AGI being $25.7k per year. This would net them a refundable tax credit of $5,637 per an online calculator I found (the calculation is tricky, so I recommend using one, there are plenty that are reputable). This lowers tax liability to zero and refunds $5,488. You read that right, this couple is now $5,488 in the black on taxes for 2020.
At this point, the couple is very happy, and rightfully so, But they haven’t even added the child tax credit yet. This credit, up to $2k per child under age 17 and partially refundable, will total another $2.8k, bringing their total tax refund to $8,288.
Total tax owed for 2020: -$8,288
Now I know we all have that friend that talks about how they just got an $8,000 tax return and how they are going to buy a new lawn mower and a state-of-the art foot massager so Karen can get her feet rubbed after work while her husband mows the lawn. Well, now you know the math behind the huge return. They probably don’t, but you do!
Moral of the story - you can make $75k as a family of 4 and not only pay zero federal income tax, but receive a refund of $8,288. Pretty crazy stuff.
Tax Considerations for the Future
As you continue to grow in your pursuit of wealth, you’ll find yourself in a spot where earning money more efficiently is required. This is where advanced mechanisms come into play, including real estate. AJ Sheff will talk more about this in the future, including the use of short-term rentals for creating a diverse stream of income that is tax-efficient.
These are simplistic examples and are not meant to express actual real-life scenarios. They are very close, however, the IRS tax code is complex, and individual circumstances can change the calculations above. For actual tax advice and help with preparation, we would recommend using a tax software or visiting your friendly neighborhood CPA.
D.C. joined the Marine Corps very young. When he left active duty, after 5 years of service, he quickly worked to get his MBA. He got his first "real" job at a modest salary and quickly worked his way up in promotions. Once he started making some money, he quickly realized he needed to learn how to save and secure his future. After nearly ten years of research, he wants to bring the knowledge and financial best practices to you so that you can also be a Wealthy Idiot.