Ch. 22:  Advanced Income Taxes

22.0 Introduction

            I’ve been lying to you.  Please forgive me.  Way back in Chapter 3, I introduced you to the US income tax system.  But I kept things simple and shielded you from the more complex considerations like deductions and tax credits.  This was necessary.  To fully understand the income tax system, one must also have a passing knowledge of tax shelters, health insurance, investment taxes, and so on.  Now you’re ready.

            In this chapter, you will learn the entire sequence that begins with total income and ends with a tax return.  As with all topics in this class, we should view these steps as merely the rules of the game.  You and I have no control over these often silly rules and regulations, but we need to intimately understand the process so that we can optimize our tax planning and live a good life.  With practice, I think you’ll discover that it’s not so hard!  By the end of this chapter, you’ll know more about the tax system than just about everyone around you.  And this knowledge should prove useful in building wealth.  As we matriculate through the steps, we will use a fictional character (“Amie”) as a case study.  That’s a good start.  But you will need to complete the practice problems to gain a keen understanding of the content.

Step 1:  Total Income

  To begin the process, we must first consider all income earned by an individual (or couple, if filing jointly).  This is nothing new for us, but let’s make sure we include all relevant earnings.  Here are four common sources of income:

• Employment Income

• Rental Income

• Investment Earnings that are taxed as income

  • • Dividends earned for stock held less than 60 days at the time of the dividend.

    • Profits generated from the sale of stocks that were held less one year or less

• Investment Earnings that are taxed as capital gains

  • • Dividends earned for stock held 60 days ore more at the time of the dividend.

    • Profits generated from the sale of stocks that were held more than one year.

    • Now hold up!  Why would capital gains be included here?  Well... it turns out that capital gains are used in the income calculation process even though they will eventually (in a later step) shift over to capital gains.  This is discussed again at the end of Step 3.

This is obviously not an exhaustive list as there are many possible income sources.  Back in 2023, I won some serious moolah playing fantasy sports—these earnings were included in my 2023 income even though they don’t fall into any of the four categories stated above.  The summation of all relevant earnings is called total income and is the necessary first step in the tax calculation process.

            This first step will (usually) only include plus-signs.  You are adding-up all income sources, not yet subtracting relevant content like traditional 401(k) contributions.  These subtractions begin in step 2.

Step 2:  Gross Income

            Once total income is calculated, we begin chipping away at this value with various subtractions and deductions.  While many of these subtractions ultimately affect taxes in the same way, it is imperative that we follow the order of operations as each step in this process is important.  To solve for gross income, we need to subtract all employee paycheck deductions. For example, in 2025, I paid about $6,000 in health insurance premiums through my employer-provided health insurance plans.  This $6,000 is subtracted from my total income when solving for gross income.

            Be careful!  The reductions included here are strictly those that are a result of paycheck deductions such that the income was never realized by the employee.  When I paid my health insurance premiums, I never had a chance to earn this income—the money was directly paid by my employer to my insurance provider on my behalf without my greasy palms ever touching it.  As a comparison, consider a person that has private health insurance that is not connected their employment.  In this case, the person earns the money first, then pays for health insurance out-of-pocket.  This is not a paycheck deduction and would not be included in the calculation for gross income.  Similarly, traditional IRA contributions are not paycheck deductions.

            Furthermore, not all paycheck deductions are relevant to taxes, so it’s necessary to understand how tax laws are applied.  I pay $25/month for a parking pass and $40/month for life insurance via paycheck deductions.  Both expenses are deducted from my salary, but they do not reduce my taxable income.  Here is a list of common paycheck deductions that do reduce taxes.  But remember that these are only relevant if paid via paycheck deduction.

• Contributions to Traditional 401(a), 401(k), 403(b), and 457(b)

• Health Insurance Premiums

• Dental Insurance Premiums

• Contributions to Health Insurance Spending Accounts (FSAs, HSAs)

• Pension Payments

Thankfully, you won’t need to make these deductions yourself.  Your employer is taking care of both the paycheck deductions and the effects they have on your taxes.  Nonetheless, to make good financial decisions, you need to understand this process.

Step 3:  Adjusted Gross Income (AGI)

            The first two steps are quite simple.  In step 1, we simply summed all relevant earnings to solve for total income. Then, in step 2, we subtracted all relevant paycheck deductions to solve for gross income.  Things get a bit messier in step 3, where we solve for adjusted gross income (AGI).

            AGI is found by subtracting above-the-line deductions from gross income.  Above-the-line deductions are a host of lucrative tax deductions that are permitted by the federal government.[1]  Some of these are already known to us.  For example, if you make traditional IRA contributions, these contributions are not made via paycheck deductions, but reduce your taxes nonetheless via an above-the-line deduction.  Similarly, if you pay health insurance premiums to an insurer that is not employer-sponsored, then your tax break will be assigned above-the-line.  Because your employer has no role in these deductions, you must play an active role to ensure all above-the-line deductions are included when you file your tax return.

There are many important above-the-line deductions to consider.  Here are a few of the most common ones:

• Health Insurance Premiums (not employer-provided)

• Health Insurance Spending Accounts (FSAs and HSAs, non employer-provided)

• Traditional IRA contributions

• Up to $2,500 in student loan interest paid

  • • Note the italics.  Only interest is deductible.  If you make $10,000 in student loan payments in 2025, but only $1,500 is towards interest, the $1,500 is the deductible portion.  Phase-out on student loan interest begins for single individual with a modified AGI above $80,000 (or $165,000 if married filing jointly); this means if your income is high enough, this benefit is reduced or eliminated.  For more information on modified AGI, check this source.  There are a lot of rules regarding the student loan interest deduction.  Most qualify, but you should do more research if your current tax situation is unique at all (for example, those that file married filing separately are not eligible).

• Some self-employment expenses

  • • If you own a business, this is where your expenses will be considered.  Your total earnings are attributed to total income and your expenses are subtracted via above-the-line deductions.  Self-employment taxes are complicated and beyond the scope of this book. 

• Many rental home expenses

  • • If you have a home that you rent for a profit, expenses are often (but not always) deductible.  Mortgage interest on rental property is usually deductible.  Real estate investing taxes are extremely complex and beyond the scope of this book.

• Some K-12 Educator Expenses

  • • Up to $300 in self-paid educational expenses for K-12 teachers can be deducted.[2]

Rules regarding above-the-line deductions change frequently, so be prepared to reassess your situation every year.  The IRS website is updated frequently (Credits and deductions for individuals | Internal Revenue Service (irs.gov)) but the information isn’t easily digested.  I will keep this list (above) up to date… I got you fam. 

            Mathematically, there is nothing difficult about above-the-line deductions.  Gross income minus above-the-line deductions equals AGI.  One you have solved for AGI, you can move on to the next step.  But, AGI is important beyond just this step.  AGI determines eligibility for various credits and other benefits.  Back in 2021, the government distributed stimulus checks to taxpayers.  To receive the maximum stimulus amount, a single person needed to have an AGI below $80,000.  AGI is also a determinant of eligibility for child tax credits, dependent card credits, and Roth IRAs.[3]  Thus, it’s key that you understand these steps in order.  If you find that your AGI is too high to be eligible for a lucrative tax break, you can reduce your AGI through various means (e.g. traditional contributions).  Note that capital gains are included in AGI; thus, capital gains can indirectly affect your income taxes through the accessibility of tax credits.

Step 4:  Taxable Income (before removing capital gains)

            Following AGI, taxpayers now consider a second round of deductions—itemized deductions.  Unlike standard deductions, itemized deductions (sometimes called “below the line deductions”) are potential deductions.  Why?  Taxpayers have the option to take the standard deduction or itemize.  Before we discuss this decision, let’s first look at the common potential itemizations one can take:

• Mortgage Interest

  • • Mortgage interest on the first $750,000 of a home loan are itemizable.  Keep in mind that this is interest only.  Repayment of principle is not deductible.

• State and Local Taxes

  • • Up to $10,000 in state taxes (such as income taxes) and local taxes (like property taxes) are deductible.  As a result, individuals that live in a state with a high state income tax rate are more likely to itemize than those living in a no income tax state like Florida.

• Charitable Contributions

• Medical and Dental Expenses

  • • These expenses are only deductible if they exceed 7.5% of your AGI (yet another reason why we need to solve for AGI).  If your AGI is $100,000 and you have $10,000 in medical expenses in 2025, only $2,500 will serve as an itemization.

There are plenty more (Credits and deductions for individuals | Internal Revenue Service (irs.gov)) but most others are quite niche.  If you’re single, you have the option of taking your itemized deductions or you may elect to take the standard deduction of $15,000.[4]  For example, suppose you sum your itemizations and find that you only have $9,000.  Thus, you have two options—take a $9,000 deduction (itemize) or take $15,000 (standardized).  Obviously, you will take the larger deduction, which is, in this case, the standard deduction.  For a couple that is married, filing jointly, the standard deduction is twice as large ($30,000).[5]

            About 90% of American taxpayers opt for the standard deduction.[6]  Younger individuals are even more likely to do so.  As one ages and their income rises, the likelihood of itemization rises since those with higher incomes typically have greater state and local tax bill, a more expensive mortgage, and greater charitable contributions.  The frequency of itemizing is also a function of economic conditions—when interest rates are high, mortgage interest costs follow suit.

            Although you are unlikely to itemize in 2025, expect significant changes in the future.  Back in 2018, the Donald Trump-sponsored “Tax Cuts and Jobs Act” significantly increased the standard deduction, which changed the tax game dramatically, cutting the frequency of itemization by about two-thirds.  This supersized standard deduction is set to expire after 2025, so the future of deductions is quite murky.  Such is life in the personal financial planning space.  You have no choice but to stay connected to changes in policies.  

            As an important aside, let’s consider a very common scenario for many college students—what is you earn less than the standard deduction.  For example, consider a single college student who earns $10,000 working during the summer.  Once the standard deduction is applied, this person is left with a negative taxable income, specifically, their tax income is -$5,000.  If this occurs, the person simply owes $0 in taxes.  Typically, this person is not required to file a tax return.  But, there are often reasons to do so anyway.  For example, their employer may have withheld taxes during the year.  All of this paid taxes is due back to the employee via a tax return.  There are plenty of other reasons why you might need to file, such as those discussed here.  Furthermore, some workers are eligible for specific tax credits that are refundable in nature, which actually can result in negative tax bill!  This concept is discussed later in the chapter. 

Step 5:  Splitting ordinary income from capital gains and determining capital gains taxes

In step five, we separate the ordinary income (taxed as income) from capital gains (taxed as, well, capital gains).  Note that capital gains are potentially relevant in determining access to tax credits and whether the individual can contribute to a Roth IRA.  Thus, capital gains can indirectly affect income taxes and other aspects of your finances.  At this point, we know the individuals ordinary income and their capital gains.  We can now directly solve for capital gains taxes, but we still have steps remaining for income taxes.  Amy had $500 in capital gains, which are subtracted from total taxable income of $54,400.  Thus, she is left with $53,900 in income (this value is used to determine where she is on the capital gains bracket) and $500 in capital gains.  Given her ordinary income of $53,900, her capital gains are taxed at the 15% rate, based on the table shown below.

Thus, Amie pays $75 in capital gains.  She will pay this tax when she files.

Step 6:  Taxes without Credits

            In step 5, we solved for taxable income ($54,400 for Amie) and split her total taxable income into taxable ordinary income ($53,900) and capital gains ($500).  These are a critically important value in the tax planning process.  Your taxable ordinary income shows you where you are on the income tax brackets and also determines your capital gains tax bracket.  For example, suppose that you are single and expect to earn a salary of $68,000 from your day job, which is your only source of income.  Without investigation, it’s unclear which tax bracket you are in!  Many mistakenly use this $68,000 in total income and surmise that they are in the 22% bracket and that any capital gains are taxed at 15%.  But you are wise and know that you must complete steps 1-5 to correctly solve for taxable ordinary income, which you find is equal to $40,500.  Applying the table below…

…you discover that you are firmly in the 12% marginal tax bracket.  Why does this matter?  As a 12%’er, you are clearly incentivized to choose Roth investments.  By analyzing your tax situation, you can make the proper investment choices, which should serve to increase your net worth significantly as you approach retirement. 

  Okay, so taxable ordinary income is important.  What next?  To move to the next step in our federal tax planning process, we merely to employ the tax brackets that we have used many times in this class (but now we are using the correct value!).  Taxable income is applied to the tax brackets.  The value that the brackets spit-out is called taxes without credits. 

Step 7:  Income Taxes (Last step!)

            In the previous step, we solve for taxes without credits.  To complete our journey, we now need to apply tax credits.  While tax deductions reduce taxable income, a tax credit directly reduces one’s tax bill.  As such, tax credits are dollar-for-dollar, more valuable.  For example, consider the usefulness of the three deductions/credits below:

1.       $1,000 above-the-line deduction

2.       $1,000 potential itemization (below-the-line deduction)

3.       $1,000 tax credit.

For our sakes, let’s assume the individual above is in the 22% bracket and does not itemize, which is a typical scenario for a college graduate in the middle of their career.  How much are these deductions/credits worth?  The $1,000 above-the-line deduction is worth exactly $220: This deduction reduces taxable income by $1,000 and taxes $220, since they are in the 22% bracket.  The $1,000 potential itemization is worth nothing!  The individual is not itemizing, so they receive no tax break from this potential itemization.  And finally, the $1,000 tax credit is worth $1,000.  A tax credit doesn’t reduce taxable income, it reduces taxes, which is far more valuable.

            The most common tax credit in the United States is the child tax credit.  In 2025, having a child (ages 0 to 16) generates a $2,000 tax credit for the caretaker(s), usually a parent or parents.  And this credit is applied per child, meaning that a married couple with three children receive a $6,000 tax credit.  Here is a short list of other popular tax credits available in the United States:

• Child Tax Credit

  • • $2,000 per child 16 and under

•  Earned Income Tax Credit

  • • Tax credit for those with low-ish incomes.  Qualifying for the credit is determine by one’s AGI and number of children that the taxpayer is caring for.  The size of the credit is also based on the number of children.  Learn more here:  Earned Income and Earned Income Tax Credit (EITC) Tables | Internal Revenue Service (irs.gov)

• Child Care Tax Credit

  • • Tax credit to those that pay for childcare expenses (e.g. daycare, nursery, pre-k, etc.), which enables the taxpayer to work.  Eligibility and size of the credit is based on AGI.  Learn more here:  Child and Dependent Care Credit: Definition, How to Claim - NerdWallet

• American Opportunity Tax Credit -and- Lifetime Learning Credit

  • • These are tax credits that may be used for folks that are working and paying for college, or, are working and paying someone else’s (like a spouse or child) college tuition.  Learn more here: Education Credits AOTC LLC | Internal Revenue Service (irs.gov).

• Saver’s Credit

  • • Fully explained below

As can be inferred from the information above, these credits are often extremely complex.  So, if you think you may be eligible, it’s going to take some effort to determine if you truly are, and if so, how much the credit is worth. 

            While I won’t discuss all of these at lengths, I think it’s a useful exercise to carefully investigate at least one of these to give you an idea of how credits are applied.  Let’s take a look at the saver’s credit[7], which is frequently useful for recent college graduates.  This credit is designed to incentivize low-ish income individuals to contribute to retirement accounts.  Specifically, a person within the proper AGI window can unlock the saver’s credit by making contributions to 401(k), 403(b), 457(b), and IRA accounts—contributions can be traditional or Roth.[8]  The maximum eligible contribution amount is $2,000 (single) or $4,000 (married, filing jointly).  The size of the credit received is based on one’s AGI, per the table below.

  So, imagine you graduate from college, are single, and earn an AGI of $24,000.  Now, that might sound like an artificially low income, but remember that this is AGI, not total income.  Furthermore, recent grads often begin their first full-time job midway through a calendar year.  A person earning a $60,000 salary is only going to realize $30,000 in total income if they begin in early July.  So, your $24,000 AGI is totally reasonable. 

  If you don’t make any retirement contributions, there would be no saver’s credit.  But, if you contribute, say, $5,000 to a Roth IRA, you are now eligible!  Of this $5,000 contribution, $2,000 is an eligible contribution for the saver’s credit.  Using the table above, your AGI of $24,000 places you in the 20% credit rate category.  Thus, 20% of your $2,000 eligible contribution, or $400, is awarded via tax credit.  You will save $400 in taxes in 2025, usually via an increased tax return. 

  You might consider getting creative to generate an even larger credit.  What if you reconsidered your retirement contributions and decided to allocated $4,700 to a Roth IRA and $300 to a traditional 401(k)?  Now, your AGI is $23,700 and you have sneakily moved into the 50% credit rate category!  You still have $2,000 in eligible contributions, but your credit is now $1,000![9]  Through diligent planning and a keen understanding of tax law, you have just manufactured significant tax savings.

  But the rules regarding eligibility for the saving’s account are not simply a result of AGI.  What if the saver’s credit results in a negative tax bill?  For example, consider a single person who has contributed $2,000 to a Roth IRA, has  an AGI of $20,000 and a taxes without credits value of $200.  Using the table above, this person should be eligible for a $1000 tax credit.  However, if we apply this credit, the individual now has a -$800 tax bill?  Verbatim, this means the person pays a negative tax, or, put another way, is given money by the government.  Is this allowed?  For the saver’s credit, it’s unfortunately not.  The saver’s credit is nonrefundable, which means that the credit cannot result in a negative tax bill.  But, some credits are fully refundable (the credit is fully available even if it results in negative taxes) or partially refundable (the credit can generate negative taxes, but the size of the credit is smaller once the tax bill becomes negative). 

  This is all such a big mess, isn’t it?  Anyway, once the tax credits have been applied, we have reached the final step and can solve for one’s tax bill.  Let’s see how Amie made out:

As is indicated by Amie’s very typical financial situation, the actual tax bill that many Americans face is a lot lower than is typically assumed by the general public.  You’ve probably heard someone say something like, “The government takes a third of my money.”  That’s possible but quite unusual, even after factoring in Social Security and Medicare taxes.  For Amie, who earned $86,000 in total income and paid $5,012 in income taxes, her effective tax rate for income taxes is only 5.83%. 

Conclusions

            From my experience, very few individuals have a solid understanding of the income tax system.  If you understand everything covered in this chapter, this probably puts you in the top 5% in tax literacy among Americans.  But there is always more to learn.  Despite years of learning, I still feel like a neophyte when it comes to this stuff.  If you want to make optimal decisions, you’ll need to plan to learn the tax rules and adapt to new changes.  And if you actually like this material, maybe should be in accounting.  Those folks get paid the big bucks for a reason!

Case Study for a Typical Person

Desiree is single and earns $51,000 from her job.  She also earns $5,000 in ordinary dividends and $8,000 in qualified dividends (all in brokerage accounts).  She makes $5,000 in Roth IRA contributions, $4,000 in traditional 457(b) contributions, and $1,500 to her HSA.  She pays $4,000 for health insurance, which is provided through her employer.  In 2025, she makes $8,000 in student loan repayments, of which $1,000 is contributed to interest.  She has $8,000 in potential itemizations and has two kids, aged 15 and 19.  Solve for her federal income taxes, capital gains taxes, Social Security taxes, and Medicare taxes.  Assume that this information is comprehensive (there is no omitted relevant information).

Income Taxes

Total Income = $51,000 + $5,000 +$8,000 = $64,000

• Included employment income, ordinary dividends, and qualified dividends.  Remember that qualified dividends will eventually be split from ordinary income, but this is later in the process.

Gross Income = $64,000 - $4,000 - $1,500 - $4,000= $54,500

• Subtracted paycheck deductions.

AGI = $54,500 - $1,000 = $53,500

• Subtracted above-the-line deductions, which in this case is interest paid on a student loan. 

Total Taxable Income (before removing capital gains) = $53,500 - $15,000 = $38,500

• Applied the standard deduction since the potential itemizations are less than the standard deduction.

***Split income and capital gains***

Taxable Ordinary Income = $30,500

Taxable Capital Gains = $8,000 (this is solved below)

Taxes Without Credits = $3,421.50

• Applied the tax brackets to taxable income.

Income Taxes = $3,421.50 - $2,000 = $1,421.50

• She got a $2,000 deduction for the 15 year-old, but nothing for the 19 year-old.  Her AGI is too high to receive a saver’s credit.

Capital Gains Taxes

Capital Gains Taxes = $0

• While Desiree has $8,000 in capital gains, her taxable ordinary income is only $30,500.  Thus, her combined taxable income and capital gains is only $38,500.  She is in the 0% capital gains tax bracket.

Social Security Taxes

Social Security Income = $51,000 - $4,000 - $1,500 = $45,500

• Social Security only considers employment income for earnings.  Desiree’s contributions to her HSA and her health insurance premiums reduce her Social Security Income.

Social Security Taxes = $45,500(0.062) = $2,821

Medicare Taxes

Medicare Income = $51,000 - $4,000 - $1,500 = $45,500

• Medicare also only considers employment income for earnings.  Desiree’s contributions to her HSA and her health insurance premiums reduce her Social Security Income.

Medicare Taxes = $45,500(0.0145) = $659.75

End Notes

[1] The stupid name, above-the-line, derives from the location of these deductions on tax forms. 

[2] I hired an accountant back in 2017 to complete my taxes.  She assigned a $300 deduction for educator expenses even though I’m not a K-12 teacher (sorry about the mistake, IRS).  She also royally bungled the tax handling of a house sale.  What a hack.  If you want something done right, do it yourself.

[3] Roth IRA is based on Modified AGI.  If a single person’s modified AGI exceeds $150,000, they are not fully eligible to contribute to a Roth IRA.  If you think this may be relevant to you, learn more here and give me some money, you rich rascal.

[4] There are separate rates for those over age 70 and the blind.  I won’t bother discussing those here, but make note if this is relevant to you.

[5] The standard deduction for heads of household is $22,500.  For those married, filing separately, the standard deduction is $15,000.

[6] Source.

[7] Technically titled the Retirement Savings Contributions Credit.

[8] Note that the 401(a) is absent from the list provided by the IRS, which can be found here: here.  Articles online state that 401(a) contributions might be eligible.  So, who knows?  HSA and other health spending accounts are not treated as retirement accounts and are thusly ineligible.  SARSEP and SIMPLE plans, which are beyond the focus of this book, are eligible.

[9] Normally, a person in the 10% or 12% income bracket should avoid traditional contributions and opt for Roth only.  This is an exception to that general rule.  

Key Terms

Above-the-line deductions:  Tax deductions specifically outlined by the federal government that are removed from taxable income early in the process (in the step where gross income is converted into AGI).  

Adjusted Gross Income (AGI):  Gross Income minus above-the-line deductions

Child Tax Credit:  For each child (aged 16 or under) that a taxpayer has, he/she/they can realize a tax credit of $2,000/year.  This credit is partially refundable (the specifics are complicated)

Fully Refundable Credit:  This tax credit's value is realized by the taxpayer, regardless of their taxes without credits value.  For example, suppose a person has taxes without credits of $200 and earns a $1,000 credit that is fully refundable.  Their income taxes paid would be -$800; they would "pay" negative taxes.  Few tax credits are fully refundable.

Gross Income:  Total Income (including capital gains) minus employee paycheck deductions

Itemized Deductions:  Tax deductions specifically outlined by the federal government that are potentially removed from taxable income late in the process.  Taxpayers will choose to take the standard deduction or itemize--whichever value is larger.  The majority of Americans do not itemize; thus, these potential deductions don't actually affect taxes for most.

Nonrefundable Credit:  A tax credit that can only be applied to reduce taxes.  The credit cannot be used to reduce one's income taxes below $0.  For example, suppose a person has taxes without credits of $200 and earns a $1,000 nonrefundable credit.  The credit reduces their taxes to $0. 

Partially Refundable Credit:  This tax credit's value is reduced, but not eliminated, once the taxpayer has reached $0 in income taxes.  For example, suppose a person has taxes without credits of $200 and earns a $1,000 credit that is 50% refundable.  The first $200 of the credit would be fully realized.  But, once the person's income taxes reach $0, they only receive half of the value of the credit for each additional dollar.  So, with $800 of partially refundable credit remaining, their income taxes would be -$400; they would "pay" negative taxes.

Paycheck Deductions:  Contributions that are made to employer sponsored plans or other categories that reduce income prior the individual earning the income.  For example, contributing to a traditional 401(k) causes income to be diverted before ever reaching the employee; thus, traditional 401(k) contributions are paycheck deductions.  On the contrary, traditional IRA contributions are made by the individual after the income is earned, so these contributions are not paycheck deductions.  Furthermore, not all paycheck deductions reduce taxes!  Most notably, Roth 401(k) contributions are made via paycheck deduction, but do no reduce taxes.

Saver's Credit:  A tax credit available to lower income individuals that can be earned by making contributions to most tax sheltered retirement accounts.

Standard Deduction:  Taxpayers can choose whether to itemize (take itemized deductions) or the standard deduction--they should take whichever deduction is larger.  In 2025, the standard deduction is $15,000 (single or married, filing separately), $22,500 (head of household), or $30,000 (married, filing jointly).

Taxes without Credits:  Total ordinary income taxes that a person pays before any tax credits are assessed.

Total Taxable Income:  AGI minus either the standard deduction or itemized deductions

Solutions

1. A single individual earns $105,000 from their job.  They do not have a brokerage account.  They pay $3,500 for health insurance that is not offered by their employer.  They contribute $5,000 to a traditional 401(k) and $2,000 to a Roth IRA.  This person has $18,000 in potential itemizations.  Solve for their income taxes; show your steps.

Total Income = $105,000

Gross Income = $105,000 - $5,000 = $100,000

• Note that the health insurance payments are privately purchased.  Thus, these payments will be attributed as above-the-line deductions.

AGI = $100,000 - $3,500 = $96,500

Total Taxable Income (including capital gains) = $96,500 - $18,000 = $78,500

Taxable Ordinary Income = $78,500

Taxes Without Credits = $12,323

• I don’t see any relevant credits.  That’s typical for a single person with a high income and no kids.

Income Taxes = $12,323

2. A married couple earns $185,000 from their job.  They do not have a brokerage account.  They pay $6,500 for health insurance that is offered by their employer.  They contribute $30,000 to a traditional 403(b) and $2,000 to a Roth IRA.  They have $36,000 in potential itemizations and $1,000 in above-the line deductions.  They have one kid, age 12.  Solve for their income taxes; show your steps.

Total Income = $185,000

Gross Income = $185,000 - $6,500 - $30,000 = $148,500

AGI = $148,500 - $1,000 = $147,500

Total Taxable Income (including capital gains) = $147,500 - $36,000 = $111,500

Taxable Ordinary Income = $111,500

Taxes Without Credits = $14,358

Income Taxes = $14,358 - $2,000 = $12,358

3. A married couple (filing jointly) has a combined $81,000 in income from their jobs.  They have one kid, aged 3.  They pay $6,000 for health insurance premiums (employer-sponsored plan).  They also contribute $10,000 to Roth IRAs.  In a brokerage account, they earn $2,000 in ordinary dividends and $5,000 in qualified dividends.  They have $6,000 in above-the-line deductions and $18,000 in potential itemizations.  Solve for their income taxes; show your steps.  Be sure to consider the saver’s credit.

Total Income = $81,000 + $2,000 + $5,000 = $88,000

Gross Income = $88,000 - $6,000 = $82,000

AGI = $82,000 - $6,000 = $76,000

• Thus, they are eligible for a saver’s credit.

Taxable Total Income (including capital gains) = $76,000 - $30,000 = $49,000

***Split***

Taxable Ordinary Income = $43,000

Capital Gains = $5,000 (assessed at the 0% bracket, so they pay no capital gains taxes)

Taxes Without Credits = $4,683

• Child Tax Credit = $2,000

• Saver’s Credit = $4,000(0.1) = $400

  • The maximum saver’s credit contribution amount is $4,000 for a couple, filing jointly.  Given their AGI, they are in the 10% saver’s credit bracket. 

Income Taxes = $4,683 - $2,000 - $400 = $2,283

4. A single individual earns $122,000 from their job.  They pay $6,500 in premiums for a comprehensive health insurance plan, through their employer, and contribute $2,000 to a medical FSA.  They contribute $20,000 to a traditional 401(k). In a brokerage account, they sell stock; specifically, they sell stock for $40,000 that they bought three years ago for $18,000.  They have $14,000 in above-the-line deductions and $11,000 in potential itemizations.  They have no kids, but do earn a $1,500 tax credit for buying an electric vehicle.

a.       Solve for their income taxes.  Show your steps.

Total Income = $122,000 + $22,000 = $144,000

Gross Income = $144,000 - $6,500 - $2,000 - $20,000 = $115,500

AGI = $115,500 - $14,000 = $101,500

• Thus, they are ineligible for a saver’s credit.

Taxable Total Income (including capital gains) = $101,500 - $15,000 = $86,500

***Split***

Capital Gains = $22,000 (capital gains taxes solved below)

Taxable Ordinary Income = $64,500

Taxes Without Credits = $9,104

Income Taxes = $9,104 - $1,500 = $7,604

b.      Solve for their capital gains taxes.

Capital Gains = $22,000

Given their taxable ordinary income of $64,500, they are in the 15% bracket

Capital Gains Taxes = $22,000*0.15 = $3,300

c.       Solve for their Social Security taxes.    

SS Income = $122,000 - $6,500 - $2,000 = $113,500

SS Taxes = $113,500*0.062 = $7,037

d.      Solve for their Medicare taxes.

Medicare Income = $122,000 - $6,500 - $2,000 = $113,500

Medicare Taxes = $113,500*0.0146 = $1,645.75

e.       It’s December of 2025, so they still have some time to make some adjustments to their situation.  If they were to suddenly contribute $5,000 to a traditional IRA, how much would this save them in federal income taxes?

With a taxable income of $64,900, they are in the 22% income tax bracket.  So, they will save $0.22 in taxes for ever dollars of reduced taxable income.  This $5,000 traditional IRA contribution reduces taxable income by $5,000. $5,000*0.22 = $1,100

5. A married couple are filing jointly.  They have no kids.  They earn a combined income of $72,000 from their jobs.  In a brokerage account, they earn $16,000 in qualified dividends and $5,500 in ordinary dividends.  They pay $6,000 for employer-provided health insurance premiums and contribute $5,000 to an HSA.  They contribute $20,000 to Roth 401(k) accounts and $10,000 to traditional 401(k) accounts.  They have $8,500 in above-the-line deductions and $15,500 in potential itemizations. 

a.       Solve for their income taxes.  Show your steps.

Total Income = $72,000 + $16,000 + $5,500 = $93,500

Gross Income = $93,500 - $6,000 - $5,000 - $10,000 = $72,500

AGI = $72,500 - $8,500 = $64,000

• Thus, they are eligible for a saver’s credit at the 10% rate.  With $4,000 in eligible contributions, they can get a $400 credit ($4,000*0.1).

Taxable Total Income = $64,000 - $30,000 = $34,000

***Split***

Capital Gains = $16,000 (capital gains taxes solved below)

Taxable Ordinary Income = $18,000

Taxes Without Credits = $1,800

Income Taxes = $1,800 - $400 = $1,400

b.      Solve for their capital gains taxes.

Capital Gains = $16,000

Given their taxable income, they are in the 0% bracket.

Capital Gains Taxes = $0

c.       Solve for their Social Security taxes.    

SS Income = $72,000 - $6,000 - $5,000 = $61,000

SS Taxes = $61,000*0.062 = $3,782

d.      Solve for their Medicare taxes.

Medicare Income = $72,000 - $6,000 - $5,000 = $61,000

Medicare Taxes = $61,000*0.0145 = $884.50

6. A single individual earns $39,000 from their job.  They pay $2,500 for employer-sponsored health insurance and contribute $3,000 to an HSA.  They don’t contribute to any retirement accounts (which is really bad because they are missing out on a company match!) and don’t have a brokerage account.  They have $1,000 in above-the-line deductions and $3,000 in potential itemizations.  They have no kids.

a.       Solve for their income taxes.

Total Income = $39,000

Gross Income = $39,000 - $2,500 - $3,000 = $33,500

AGI = $33,500 - $1,000 = $32,500

• They would be eligible for a saver’s credit, but they didn’t make any eligible retirement contributions!

Taxable Income = $32,500 - $15,000 = $17,500

Taxes Without Credits = $1,861.50

Income Taxes = $1,861.50

b.      It’s December of 2025, so they still have some time to make some adjustments to their situation.  They decide to contribute $10,000 to a traditional 401(k).  Re-solve for their income taxes now.  How much income taxes did they save by making this $10,000 contribution?

Total Income = $29,000

Gross Income = $29,000 - $2,500 - $3,000 = $23,500

AGI = $23,500 - $1,000 = $22,500

• Now they are eligible for a saver’s credit.  With a $2,000 eligible contribution (the max for a single person), and their low AGI, they have a $1,000 credit ($2,000*0.5).

Taxable Income = $22,500 - $15,000 = $7,500

Taxes Without Credits = $790

Income Taxes = $0

• The saver’s credit is non-refundable so it can’t take this person to a negative income tax level.  Think of how valuable these 401(k) contributions are!  By making $10,000 in traditional 401(k) contributions, they save $1,916 in taxes, unlock the company match on their 401(k), and are now on the path to retirement.  It’s so crucial to take advantage of such benefits, but I understand it can be very difficult for someone with a low income like this.