The Commerce Clearing House puts out a compilation of the tax code and all of its statutes with notations and relevant cases. In total it is 70,000 pages! To make matters worse, the tax code is constantly changing and growing rapidly. In fact, the compilation has grown by 40,000 pages since 1990.
To put it lightly, taxes can be extremely complex, but there are some basic concepts that anyone can grasp which will make it easier to understand where your hard earned money is going (and why). Here are some of those fundamental rules and principles.
A household or individual’s gross income is the total amount of income that is earned from all sources. This number is indicated on the 1040 as “Wages, Salaries, Tips, Etc.” For most people who are employed, this number will be indicated on their W2 as “Wages, Tips and Other Compensation,” but can also include income from business interests, rental income, social security, investments and pensions. At the highest level, this number represents all of the money you have received from an employer or other outside sources before any deductions.
Adjusted Gross Income
Your Adjusted Gross Income, or AGI, is all of your income minus certain payments you’ve made during the year. These payments are sometimes referred to as “Above the Line Deductions” and include:
- Educator expenses
- Certain business expenses
- Deductible HSA contributions
- Moving expenses for military
- Deductible self-employment taxes
- Contributions to retirement plans or health insurance for self-employed people
- Penalties on early withdrawals of savings
- Alimony paid
- Deductible IRA contributions
- Student loan interest
- Deductible tuition and fees
This number is very important because it is the basis the IRS will use to calculate your taxable income and to determine which deductions and credits you may qualify for.
Modified Adjusted Gross Income (MAGI)
This number is your AGI with some deductions added back in. The MAGI will determine certain deductions and credits and the AGI will determine other deductions and credits.
Here is a quick example as to why there are two different numbers:
To determine the AGI, we reduced our gross income by the amount you made to an IRA but in order to determine what we can ultimately deduct from our taxable income from this contribution we need to add it back in. In other words, we can’t take the deduction to determine whether we can take the deduction.
This number is not reported on your 1040 but simply used to determine what you can use as an above the line deduction or a tax credit.
Now that you have your AGI and the tax credits you qualify for, you now can determine your taxable income. To determine your taxable income, you will take your AGI and reduce it using a standard deduction or itemized deductions.
Since the tax code changed in 2017, most people have been taking the standard deduction which is a flat amount based on the way you file your tax return. For instance, if you are filing your taxes under a single status you can reduce your AGI by $12,950 and if you are filing under a married filing jointly status you can reduce your AGI by $25,900. This reduction will give you your taxable income and will be used to calculate your total tax.
In some cases, it does make sense to make itemized deductions. You will use itemized deductions over the standard deduction when your possible itemized deductions are higher than your possible standard deduction. Since the tax laws were amended in 2017, popular itemized deductions were capped making it difficult to to have enough itemized deductions that total an amount that is higher than a standard deduction. Some itemized deductions include business expenses, property taxes, mortgage interest and charitable donations.
Marginal Tax Brackets
Now that you have your taxable income, you can determine your tax. The federal government uses what is called a progressive tax which means that income levels will determine what tax rate you will pay.
Marginal Tax Brackets for Tax Year 2023
|Tax Rate||Single filers||Married filing jointly or qualifying spouse||Married filing separately||Head of household|
|10%||$0 to $10,275||$0 to $20,550||$0 to $10,275||$0 to $14,650|
|12%||$10,276 to $41,775||$20,551 to $83,550||$10,276 to $41,775||$14,651 to $55,900|
|22%||$41,776 to $89,075||$83,551 to $178,150||$41,776 to $89,075||$55,901 to $89,050|
|24%||$89,076 to $170,050||$178,151 to $340,100||$89,076 to $170,050||$89,051 to $170,050|
|32%||$170,051 to $215,950||$340,101 to $431,900||$170,051 to $215,950||$170,051 to $215,950|
|35%||$215,951 to $539,900||$431,901 to $647,850||$215,951 to $323,925||$215,951 to $539,900|
|37%||$539,901 or more||$647,851 or more||$323,926 or more||$539,901 or more|
The federal income tax is progressive, meaning your tax rate goes up as your income goes up.
The common misconception is that once you hit a certain bracket, your entire taxable income is taxed at this amount. But, instead, everyone is taxed at the same rate within each bracket. Allow me to further explain using an example.
Let’s say you are filing your taxes using a single filing status and you determine that your taxable income is $200,000. Here is how you will determine your tax.
The first $10,275 of income is taxed at zero percent.
The next $31,499 (or $41,775 – $10,276) is taxed at 12% = $3,779.88
The next $47,299 (or $89,075 – $41,776) is taxed at 22% = $10,405.78
The next $80,974 (or $170,050 – $89,076) is taxed at 24% = $19,433.76
And the final $29,949 is taxed at 32% = $9583,68
You total these all up to get your total tax of = $43,203.10
The effective tax rate, which is the total total tax payable as a percentage of taxable income, will always be lower than the highest marginal tax rate. Here the highest marginal tax rate is 32% and the effective tax rate is 21.6% or $43,203.10 divided by $200,000
Now that you have your tax number, you can calculate your total tax by reducing your tax amount by any tax credits that you determined you qualify for using MAGI and AGI. Many people confuse tax deductions with tax credits where credits reduce the total tax you owe and deductions reduce the amount of taxable income you will use to determine your tax. All things being equal, a tax credit is way more powerful than a deduction when trying lower tax liability.
Now that you have the total amount of tax you owe, you can determine how much of a credit or how much more tax you owe by taking your total tax and subtracting that amount from the amount of tax your employer withheld or the amount you paid in estimated tax payments.
For those who are employed and receive a W2, you can find this number on your W2 indicated as “Federal Tax Withheld”. For example, if your total tax is $10,000 and your employer withheld $12,000 then you will receive a refund of $2,000.
In some cases, you may have to pay an additional tax called capital gains tax. This tax may be applicable if you sold an asset at a higher price than what you bought it for, like investments or real estate.
In other cases where you sold an asset at a loss, you may be able to reduce your taxable income. This calculation can be a bit more complex for this stage and it is important to consult with your tax advisor if you have received a 1099 outlining capital gains or sold an asset at profit or a loss.
Related: Turn Investment Losses into Tax Breaks with Tax-Loss Harvesting
If you have any questions about anything we discussed or have general questions about your financial situation, you’re welcome to schedule a complimentary consultation using the link below.
Disclaimer: Our firm provides the information on its website for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation.