How Taxes Actually Work
Now that it’s the beginning of the new year — for some of you, you might already be thinking about what your taxes will look like for this past year, so you can plan accordingly as it gets closer to April 15th.
And if you’re like most Americans, you’ll likely be looking to your tax accountant or at least a tax preparation software, like turbo tax, to process your filings.
But have you ever wondered exactly how your taxes are calculated and why some people end up getting refunds and others end up paying hefty tax payments at the end of the year?
Well, if you have, then you’re in luck — because I built this very simple tax calculator on excel that outlines the exact process by which the IRS determines how much taxes you owe or should get back. And in this article, I’ll be walking you guys through that spreadsheet, step by step, so you can get a clear understanding of how this works.
But remember, I’m not a licensed accountant and this is only a high level exercise to explain the concepts of federal tax calculations — so read till the end where I’ll also talk a little bit about why it’s a good idea for you to speak to a certified CPA when filing your taxes or at least utilize tax preparation software like TurboTax.
So let’s dive right into the simple tax calculator that I built in excel.
When you are doing your taxes, there are 5 basic steps:
1) Gross Income. First you’ll have to figure out what your gross yearly income is — and typically when you are filing your taxes with TurboTax or an accountant, you’ll enter in all of your sources of income individually to get to an aggregated total.
These sources might include all of your wages from work, interest that your bank may have paid you, capital gains from selling stocks, rental property income, etc. But today, for the sake of simplicity in this model, let’s just say we’ve already combined all of that and our total gross income for the year was $60,000 dollars.
2) Tax Deductions. Next you determine what tax deductions you have. A tax deduction is an allowable reduction of your taxable gross income by any one of the IRS approved expenses. Basically, for certain types of expenses, the government says, for these types of things, we’ll give you a tax break and reduce your gross income number by the amount you spent on these expense.
One example of this is the Educator’s Expense Deduction. If you’re an educator and you had to use some of your own money to purchase education supplies, then the IRS will let you deduct up to $250 spent on classroom supplies.
Additionally, a Charitable Donation is another form of deduction. For this one, you can claim up to $300 dollars of donations without having to provide itemized documentation, or up to 60% of your gross income generally, with itemization. Let’s say that we donated $1,000 dollars last year.
So once your deductions are done, that leads you to your Adjusted Gross Income — which is basically the starting value upon which the IRS calculates your taxes owed.
3) Tax Brackets. The way tax calculations are done is that there are varying percentages for how much you owe based on your income bracket. If you look at this chart — it shows that if you make $9,875 dollars or less, you are taxed at a 10% rate. If you make between $9,876-$40,125, then you get taxed at 12% — and so on and so on for the other brackets.
But the thing that confuses a lot a people, is the fact that this percentage is not applied to your total adjusted gross income, but only the amount that falls within these income levels. What that means is that, in the case of our example, a $58,750 yearly adjusted gross income, spans across 3 different income levels — in the manner shown in the image.
The first $9,875 dollars fall within the first level, $30,250 fall in the 2nd level and only the remaining $18,625 fall within the 3rd level. So if you apply the respective tax percentages to the amounts that fall within each level, you end up with $988 dollars of taxes owed from the first level, $3,630 dollars of taxes from the 2nd level, and $4,097 of taxes from the 3rd level — for a total of $8,715 dollars of taxes owed.
4) Tax Credits. But we’re not done yet — the next step is to take a look at your tax credits. Now, the difference between this and a tax deduction, is that a tax deduction reduces the total gross income upon which your taxes are calculated. But a tax credit, literally reduces that amount of taxes owed.
An example of a tax credit is the Child Tax Credit. A Child Tax Credit gives you a $2,000 credit per qualifying dependent child 16 years of age or younger, at the end of the calendar year. And let’s say for this exercise, you have 2 kids — that’s a $4,000 tax credit.
5) Taxes Already Paid. And finally, we need to take into account how much federal taxes you’ve already paid, at each paycheck, through payroll deduction. As you’re probably already aware, the IRS automatically takes a portion of your paycheck to pay for the anticipated taxes you will owe, at the end of the year. This helps provide cash flow for the IRS throughout the year and also prevents a large tax bill for you at the end of the year. Let’s say that your payroll tax withholdings were set at 12% of your $60,000 dollars of gross income — meaning you’ve paid $7,200 dollars in taxes throughout the year.
Well, in this case, after all is said and done, it looks like you are eligible for a tax refund of $2,485.
That is the general methodology behind how your taxes are calculated each year. If you’d like to download this simple tax calculator (for free) and play around with the numbers yourself, simply click the link to my website here.
And lastly, while this exercise is a quick and easy way to learn how taxes are calculated and to get a high level estimate as to how much taxes you might owe or get back at the end of the year, you’ll definitely want to utilize a professional tax accountant or at least professional tax software like turbo tax to properly do your filings.
A tax professional or tax software will be able to walk you through every type of deduction or credit that you might be eligible for and also manage any complicated tax situations you may have, like how to account for numerous financial transactions within your brokerage accounts or how to properly cover rental and investment properties — and most importantly, how to file in a manner that provides you the least risk of audit.
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The content here is strictly the opinion of Daniel’s Brew and is for entertainment purposes only. It should not be considered professional financial, investment or career advice. Investing and career decisions are personal choices that each individual must make for themselves in accordance with their situation and long term plans. Daniel’s Brew will not be held liable for any outcome as a result of anyone following the opinions provided in this content.