Chapter 3:  The Basics of Income Taxes

DISCLAIMER—THIS CHAPTER IS MERELY AN INTRODUCTION TO TAXES.  IN THIS CHAPTER, I DON’T DISCUSS DEDUCTIONS AT ALL.  BASICALLY, I’M LYING TO YOU, BUT WE HAVE TO START SOMEWHERE.  BY THE END OF THIS BOOK, YOU WILL HAVE A FULL PICTURE ON THE US TAX SYSTEM.  BUT WE NEED TO LEARN TO CRAWL BEFORE WE WALK.

3.0 Introduction

            Tax planning is a key element of personal finance.  While there are other difficult financial decisions that a person makes—career selection, marriage, buying a house, etc.—successful tax planning often allows for massive increases in a person’s net worth with surprisingly little effort!  This is the true low-hanging fruit of financial planning.  Unfortunately, the US tax system is incredibly complicated.  In this section, we consider the basic principles of income taxes.  We will circle-back on these concepts in Chapter 22.

3.1 What is Income

            Well, this kind of seems like a dumb section… what is income?  Psh… everyone knows what income is!  Well, maybe not.  Suppose that the government sends me a stimulus check for $500.  Is this income?  Probably, but not always.  What if I earn $400 in investment profits on stocks.  Is this income?  It depends.  What if I take some of my earnings from my job and use it to buy health insurance?  This might be income… it depends.  This is not so easy.  Even much of your salary will not qualify as income!  For now, let’s just assume that you already know how much taxable income you have and leave these complex considerations for future self (poor future self, that bastard is always doing the heavy lifting).

3.2 The US Income Tax System

            Table 3.2.1:  U.S. tax system for single individuals

The table above displays the income tax bracket for a single filer (unmarried) in the United States for income earned in 2025.[1]  Every year, these tax brackets are adjusted by the federal government, often merely tweaked to counteract inflation.  Let’s jump right in.  Suppose you have a taxable income of $20,000.  How would we solve for your taxes?  First, let’s see how Donny Dumbass would solve for this.  As you might imagine, Donny Dumbass is a dumb ass.  So, let’s see if we can catch his mistake.

Every semester, several students will make this mistake.  Don’t be like Donny Dumbass.  The mistake Donny made was that he failed to recognize that this is a marginal tax system.  In a marginal tax system, dollars are not treated collectively, but are instead considered as independent units that are taxed separately.  If Donny Dumbass were correct, we would have some very strange incentives.  For example, imagine you are currently earning $48,000 per year.  In Donnie’s view, all of your income would be taxed at 12%.  If you were to suddenly receive a $1,000 raise, which adjusts your total income to $49,000, your entire $49,000 would be taxed at 22%.  After taxes is applied, you would have less take-home pay once taxes are applied! This would be a horrible tax system.

  We learned the wrong way.  Now, what’s right?  When you earn $20,000, the first $11,600 will be included in the 10% bracket.  The remaining $8,400 spills-over into the 12% bracket.

            Taxes paid = ($11,925)(0.1) + ($20,000-$11,925)(0.12) = $2,161.50 [2]

Rather than providing an explanation, I think more examples will make this click.  See if you can arrive at the correct answers below

Income = $50,000

·        Taxes paid = ($11,925)(0.1) + ($48,475 - $11,925)(0.12) + ($50,000 - $48,475)(0.22)

·        Taxes = $5,914.00

Income = $80,000

·        Taxes paid = ($11,925)(0.1) + ($48,475 - $11,925)(0.12) + ($80,000 - $48,475)(0.22)

·        Taxes = $12,514.00

Income = $150,000

·        Taxes paid = ($11,925)(0.1) + ($48,475 - $11,925)(0.12) + ($103,350 - $48,475)(0.22) + ($150,000 - $103,350)(0.24) 

·        Taxes = $28,847.00

Income = $1,000,000

·        Taxes paid = ($11,925)(0.1) + ($48,475 - $11,925)(0.12) + ($103,350 - $48,475)(0.22) + ($197,300 - $103,350)(0.24) + ($250,525 - $197,300)          (0.32) + ($626,350 - $250,525)(0.35) + ($1,000,000 - $626,350)(0.37) = $327,020.25

The marginal tax system may be strange, but it’s logical (unlike many other characteristics of our tax system).  The marginal tax system guarantees that increases in total income will always lead to increases in net income.  So a raise or bonus will always result in higher take-home income for you, even after taxes are applied.

  It’s also important to note that the U.S. tax system is progressive.  As your income rises, the tax rate that you face (generally) increases.  If you receive a $1,000 pay raise, the taxes you face on this raise are correlated with the current income.  Those that have a higher income will receive a lower net pay from this raise.

Table 3.2.2:  U.S. tax system for married individuals and those filing as “head of household”

The initial table provided in Table 3.2.1. showed the tax system for single individuals.  If you are not married and have no dependents, this is the tax system you will use (with some rare exceptions).  Chance are, at some point, you will get married.[3]  At this point, your tax system gets more complicated.  Typically, getting married will not hurt your tax situation; rather, marriage often reduces your combined tax liability.[4]  In most cases, married individuals will choose the “married, filing jointly” option when completing their tax returns.  In this case, the married couple’s incomes will be combined.  The example below displays a scenario where marriage reduces this couple’s taxes.

Example:  Single vs. married tax scenario

Single individuals

Chris:  Income = $40,000

Taxes paid = ($11,925)(0.1) + ($40,000-$11,925)(0.12) 

Taxes paid = $4,561.50

Jessie:  Income = $120,000

Taxes paid = ($11,925)(0.1) + ($48,475 - $11,925)(0.12) + ($103,350 - $48,475)(0.22) + ($120,000 - $103,350)(0.24) 

Taxes paid = $21,647.00

Combined Taxes = $26,208.50

Married, filing jointly

Chris and Jessie’s income = $160,000

Taxes paid = ($23,850)(0.1) + ($96,950 - $23,850)(0.12) + ($160,000 - $96,950)(0.22)

Combined Taxes = $25,028.00

For Chris and Jessie, marriage leads to a reduction in overall taxes.  Note that part of Jessie’s income was taxed at 24% prior to marriage; after marriage, none of their combined income is taxed at 24%.  Chris and Jessie have unequal incomes; couples like this generally earn the largest tax benefits from marriage. 

            In some cases, a married couple may choose to keep their finances disconnected and “file separately”.  This normally leads to a greater income tax bill, but in some cases, typically when the couple has similar incomes, the choice to file separately will reduce their tax bill.[5]  If Chris and Jessie decide to file separately, each would individually find their tax burden by using the middle columns in Table 3.2.2.  While choosing to be “married, filing separately” is rare, there are some interesting examples where it can be the superior choice.

            Finally, you may also have the option to file as the “head of household”.  This option is available to some single individuals that have dependents.  Imagine for example that you are married and have three kids.  But, you and your spouse get divorced and your spouse moves out (leaving you with the kids).  Since you will likely be bearing the brunt of the financial burden of caring for your dependents, the IRS has provided you with the option to file as the head of household, which offers a lower tax bill compared to filing single. 

3.3 State Income Tax Systems

            In addition to the federal income tax system, you may also face state income taxes.  The tax systems applied by U.S. states greatly vary.  Some states, such as Tennessee, Florida, and Texas, do not charge a state income tax.  Other states, such as California, levy significant income taxes on the wealthy, with marginal tax rates as high as 13.3%.  In Georgia, my state of residence, earners face a flat 5.29% tax rate on all income, regardless of marriage status.  So, an individual earning $100,000 faces $5,290 in Georgia state income taxes (ignoring deducions and such).

  State tax rates, even California's, are low compared to federal rates.  Thus, federal taxes are usually the driving force of personal financial choices related to taxes and will serve as the primary focus in this book.  For simplicity, many of the example questions in this text are posed under the assumption that the individuals work in Florida, which has no income tax system.  

3.4 Social Security and Medicare Taxes

            In addition to federal and state income taxes, workers in the US are also required to pay Social Security and Medicare taxes.  Social Security is a federal program that takes money from current workers and pays retirees and those with disabilities that prevent them from working.  It’s a complicated system that we will fully cover in a later chapter.  For now, let’s just consider the general tax implications of Social Security.  For most, the Social Security system will charge a 6.2% tax on your primary earnings (i.e. from your full-time job), regardless of your marital status.  For example, if you earn $100,000 as an accountant, you will pay $6,200 in Social Security taxes. If you get married, and your combined income is now $200,000, you and your spouse will pay $12,400 in Social Security taxes.[6]

            Medicare is a US federal system that takes money from the currently employed to pay for medical expenses, generally for individuals over the age of 65.  For most, the Medicare system will charge a 1.45% tax on your primary earnings.  For example, if you earn $100,000 as an accountant, you will pay $1,450 in Medicare taxes.  As with Social Security, this tax system is pretty much the same for everyone, regardless of marital status.

3.5. Taxes and You

            I’ve really lied to you a lot in this chapter.  All four tax systems discussed (federal, state, Social Security, and Medicare) have far too many complex considerations for us to consider at this point.  You need more knowledge before we can really dive in!  But my hopes are that this introduction will provide perspective on the type of taxes you face and how these systems work.  

Footnotes

[1] Taxes must be filed the following year by the tax date (normally April 15th). 

[2] In reality, the Internal Revenue Service (IRS) rounds-down all tax charges.  So, this person would only owe $29,042.  For simplicity, we will ignore this trivial matter.  Fifty-cents is not going to affect our retirement goals.

[3] Nearly every demographic category in the US is likely to marry before age 35.  Source:  https://www.cdc.gov/nchs/products/databriefs/db19.htm

[4] Significant other dragging their feet?  Tell them they might be able to reduce their taxes if they get married!  Story time—A good friend of mine secretly got married for the tax break.  They didn’t even tell their parents.  When they had their wedding ceremony, they had already been married for two years. 

[5] In this scenario, staying single would have led to a lower tax bill.  But, filing “single” is not permitted when married. 

[6] But, this is not a “true tax”.  The more your pay into Social Security, the greater the benefits you will receive later in life.  

Key Terms

Marginal Tax System:  A tax system where dollars are taxed independently and at different rates.  If earn $20,000 and you earn $100,000, your first $20,000 earned will be taxed the same as my $20,000, but the additional income may be taxed differently.  The US income tax code applies a marginal tax system.

Medicare:  A federal program in the United States that diverts money from current workers to cover medial expenses for some individuals over the age of 65

Net Income:  Income remaining after paying taxes

Net Worth:  The total value of a person’s (or household’s) assets minus liabilities.  Usually, assets include retirement accounts, bank accounts, cash, and (possible) housing equity, while liabilities are personal debt.

Progressive Tax System:  As your income rises, the tax rate that you pay increase.  This is the case for both the U.S. and Georgia tax systems. 

Social Security:  A federal program in the United States that diverts money from current workers to retirees and those with disabilities

Practice Problems

1. Calculate the following for a single person that is earning $15,000 in a year.  Assume this person lives in Georgia.  Solve for the following…

a. Federal income taxes paid = 

($11,925)(0.1) + ($15,000-$11,925)(0.12) = $1,561.50

b. State income taxes paid = ($15,000*0.0529) = $793.50

c. Social Security taxes paid = $15000*0.062 = $930

d. Medicare taxes paid = $15000*0.0145 = $217.50

e. How much does this person earn in “net income” once all taxes are considered?

Subtract all taxes from total income

Income = $15,000

Taxes = $3,502.50

Net Income = $11,497.50

2. Calculate the following for a single person that is earning $85,000 in a year.  Assume this person lives in Florida.  Solve for the following…

a. Federal income taxes paid = $13,614

b. State income taxes paid = $0 (Florida doesn't levy a state income tax)

c. Social Security taxes paid = $5,270.00

d. Medicare taxes paid = $1,232.50

e. How much does this person earn in “net income” once all taxes are considered? 

Take $85,000 and subtract the answers from above.

Answer = $64,883.50

3. Calculate the following for a married couple (filing jointly) that is earning a combined income of $108,000.  Assume they work in Florida.  Solve for the following…

a. Federal income taxes paid = $13,588

b. State income taxes paid = $0 (they work in Florida)

c. Social Security taxes paid = $6,696

d. Medicare taxes paid = $1,566

e. How much does this couple earn in “net income” once all taxes are considered? $86,150

4. Angela earns $52,000 and Dwight earns $44,000.  For now, they are single.  Solve for their federal income taxes if they stay single.

Angela income taxes = $6,354

Dwight income taxes = $5,041.50

Combined Taxes = $11,395.50

5. Angela earns $52,000 and Dwight earns $44,000.  Solve for their federal income taxes if they get married and use the “married, filing jointly” tax system.

Combined Income = $96,000

Combined Taxes = $11,043

6. Angela earns $52,000 and Dwight earns $44,000.  Solve for their federal income taxes if they get married and use the “married, filing separately” tax system.

Angela income taxes = $6,354

Dwight income taxes = $5,041.50

Combined Taxes = $11,395.50 (note that this is the same as single! But the tables for single and married, filing separtely are not exactly the same... check out the brackets at the highest income levels.)

7. Let’s focus solely on federal taxes.  Suppose that I am single and currently earn $11,925.  I am offered a side job to earn an extra $5 in taxable income.  Will this small raise increase or decrease my net income?  Explain and/or mathematically solve.

Increase!  When pre-tax income rises in a marginal system, net income also rises.  The mistake that people make here is to think that all of your money will be taxed at a higher rate.  This is not the case.  Instead, if your income rises from $11,925 to $11,930, only the additional $5 will be taxed at the 12% rate.

8. Annie, who is single and lives in Florida, earns $110,000 in gross income in 2025.  She must pay federal income taxes, Social Security taxes, and Medicare taxes.  She spends $48,000 and puts the rest of her net income in a savings account that earns 4.4% interest, compounded monthly.  If she makes no other contributions, how much money will be in her savings account in 44 years?

This is a time-consuming question, but every step is easy if you are organized and take your time.

Solve for all taxes.

Federal income taxes = $19,247.00

SS taxes = $6,820

Medicare taxes = $1,595

Total Taxes = $27,662.00

Spending 

$48,000 (provided in the question—this does not affect taxes but does impact savings)

Amount Invested

$110,000 - $27,662 - $48,000 = $34,338

FV = $34,

$34,338[1 + (.044/12)]44*12 = $237,154.52

9. A married couple living in Florida earns $95,000 in gross income in 2025.  They spend $47,000 and put the rest of their net income into stocks that earn 8.4% interest, compounded annually.  If they makes no other contributions, how much money will be held in stocks in 15 years? Assume they are “married, filing jointly”.

Federal income taxes = $10,923

SS taxes = $5,890

Medicare taxes = $1,377.5

Taxes = $18,190.50

Spending = $47,000 (provided in the question—this does not affect taxes)

Amount Invested = $95,000 - $18,190.50- $47,000 = $29,809.50

FV = $29,809.50[1 + .084]15  = $99,952.56