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If you are still reading this, congrats! Many people "turn off" when they read anything related to taxes. Before I became an accountant, I honestly would have done the same. The purpose of this post is to give you a basic understanding of how your income is taxed. Don't worry - I'm not looking to transform you into an accountant - but I believe it's essential for every person to at least have some level of tax literacy. If you are someone who hands over their tax documents to an accountant each year, or even if you do your own taxes, this post is for you. My job is to make this post as painless as possible, so that you keep on reading. No pressure! So, here is how we’re going to do this: We’re going to discuss three tax concepts, and once that’s done, you should have a solid foundation of essential tax knowledge.
Tax Brackets
I bet you have heard of this one. The basic idea is the more income you earn, the larger percentage of tax you will pay to the IRS. A "tax bracket" is a rate of tax you will pay for a particular level of income. For example, in 2023, if you are filing as married filing jointly together with your spouse, the first $20,549 of taxable income you earn will be taxed at 10%. (“Taxable income” is basically all your annual income – think your W-2 salary, interest, business income, sale of stock, etc.) Any taxable income you earn above $20,549 but less than $83,350 will be taxed at 12%. This will keep increasing until a potential maximum of 37% of some of your taxable income will go to the IRS. People often complain about how large a percentage of their income goes to taxes. Don’t get me wrong – even 1% is too much. But here is a great piece of info for some historical context: Back in 1944, the highest tax rate was 94%. Read that again. Maybe things aren’t too bad after all? One final word about tax brackets: Some people mistakenly assume that once they "hit" a certain bracket, ALL their income will be taxed at that rate. This is incorrect. Only the portion of taxable income in the higher bracket will be taxed at the higher rate. For example, even if the upper portion of your income hits the 24% bracket, not all your income will be taxed at 24%.
Free Income
Did someone say “free?” Here is the rundown: The government gives you a freebie each year by letting you exclude a certain amount of income from your taxable income. Hey, the IRS isn't all bad! How much can you exclude? You have two options:
Option 1: The standard deduction - the IRS gives you a fixed amount of free income each year. For 2023, if you're single, this amount is usually $13,850, and if you're married filing jointly, this amount is usually $27,700. You can either choose this amount as free income - OR - you can instead choose:
Option 2: To itemize your deductions on a form called Schedule A and take THAT amount as your free income. If your total Schedule A amount is more than your standard deduction amount, it would be more beneficial for you to "itemize." What type of deductions can you claim on Schedule A? The more popular items on this itemized list are mortgage interest, property taxes and charity, although there are others. As an example, if you’re filing as married filing jointly and in 2023 you paid $10K of property taxes, $10K of mortgage interest and $8K of charity, it would make sense for you to itemize since the total of these items ($28K) is more than the standard deduction ($27,700).
Tax Credit vs. Tax Deduction
Do these seem like the same thing to you? They’re not. One of them is much more valuable than the other. A tax credit directly reduces the tax amount that you owe, dollar-for-dollar. A tax deduction only reduces your taxable income. Still not totally clear what this means? Let’s say you have the option of taking a $2,500 tax credit or a $2,500 tax deduction. While the credit will save you $2,500 by directly reducing the tax that you owe by $2,500, the deduction will only reduce your taxable income by $2,500. If you're in the 22% income tax bracket, that amounts to a tax savings of only $550 (i.e. $2,500 X 22%). This is a great example of why tax credits are generally more valuable than tax deductions. Some examples of tax credits are the Child Tax Credit, the Earned Income Credit and certain educational credits. Some examples of tax deductions are traditional IRA contributions, student loan interest and the Educator Tax Deduction.
Taxes are certainly not the most exciting topic to discuss. However, I hope this post was successful in conveying some key tax ideas you can use moving forward.
>Accounting insights by Aaron Shleifstein from A. Shleifstein & Co. CPA's.
A. Shleifstein & Co. CPAs is a full-service accounting firm, offering white-glove service. You've worked hard building your business. You continue doing your thing, while we handle all of your tax filings and help limit your tax liabilities.
