How Understanding Taxes Puts You in the Driver's Seat in Your Finances.
As a millennial have you ever wondered why taxes even matter or what implications they have on your life?
There isn't just 1 kind of tax. There are federal taxes. Social Security taxes. Medicare Taxes. Property taxes if you own a home. Self-employment taxes potentially if you are a small business owner. State taxes and sales tax (for most of us). And the list keeps going. But today let’s focus on Federal Taxes as that's where the bulk of your tax bill will generally come from every year. If you understand this stuff, it can really help make a lot of decisions easier and take away the stress and feelings of incompetency. So here we go...
The U.S. has what's called a Marginal Tax system (sometimes also referred to as Progressive). It simply means that the more you earn, the higher tax percentage you will pay per dollar earned. The thought is that people who make $15,000 per year shouldn't pay the same tax rate as someone who makes $5,000,000 per year.
In this post, I talked about something called "the standard deduction". In 2019, the standard deduction is $12,200 for Single folks and $24,400 for married couples. So what is the standard deduction? Essentially, it's a tax-free zone -- the amount of income you can earn before you have to pay any federal taxes to the government. Meaning, if you are single, you don't have to pay any federal taxes on the first $12,200 of gross income you make.
But what if you make more than $12,200 every year?
Well, every dollar you make over $12,200 is now subject to federal tax, and the tax percentage gets higher and higher the more money you make. Here's the percentages and brackets for 2019:
After $12,200 (the "tax free zone"), the next $10,000 of your gross income is taxed at 10%.
Then after $22,200 (the $12,200 "tax-free zone" plus $10,000), the next $30,000 of gross income is taxed at 12%.
After $52,200, the next $44,000 of your gross income is taxed at 22%. And it keeps going up from there -- to 24%, to 32%, to 35%, and finally to 37%.
And it starts over every single year. It doesn't matter if you make $5,000,000 per year. Every single year, the first $12,200 is tax-free, the next $10,000 is at 10%, the next $30,000 is at 12%, and so on and so forth.
So why does this matter? Well, it's important to know where you are at in the tax brackets so you can make informed decisions and ultimately, retain as much of your hard-earned money as you can!
I frequently get asked by friends who just got their first job out of college whether they should open a Roth 401(K) or a Traditional 401(K)/IRA. Well, knowing where you sit in the tax brackets can help shed light to that decision.
If you make $40,000 per year, you know you are in the 12% tax bracket (if you're single), which by historical standards, is a super-low bracket to be in. Would you rather know you're going to pay 12% tax now and then put the money into a Roth account and know you'll never pay taxes again? Or would you rather put money in a Traditional account and avoid paying the 12% tax this year and hope you are paying 12% or less on taxes when you pull the money out 40 years from now in year 2059?
Remember, the standard deduction ($12,200 for single, $24,400 for married) is a "tax-free" zone. So if you put all of your money into Roth accounts from now until you retire and your plan is to solely take money out of Roth accounts and Social Security to fund your retirement, you're potentially leaving money on the table in the form of not using any of that "tax-free" zone. If you were single, you could have taken $12,200 from a Traditional 401(K) or Traditional IRA and it wouldn't have been taxed! So depending on your situation, it may not be wise from a tax perspective to put all of your money in Roth accounts if your plan is to solely fund your retirement with Roth accounts and Social Security.
These are all things that I bet a lot of 70-year old's wish they knew when they were 25 years old.
Let's do a few more examples to hopefully show how useful this is to you:
You're considering starting a side-business to supplement your primary job's income and you know (because you read this) that you're at the very top of the range of the 12% bracket.
Then you know that if you generate any more income from that side-business you will be paying 22% on that additional income, rather than 12%. Knowing that for each dollar you earn, you will only keep 78 cents per dollar (1 dollar less 22% tax) rather than 88 cents per dollar (1 dollar less 12% tax) is something I think is very valuable.
Or say you inherit some money from your deceased grandmother and it's sitting in a Traditional IRA (taxable account upon withdrawal from it). Should you take more of the money out of the inherited Traditional IRA than you are required by law this year or not? If you are a grad school student and you only make $5,000 a year from your part-time job at Chili's, it might be something to consider because the first $12,200 of income you generate from all sources is tax-free federally.
Remember, federal taxes are not the only type of taxes you pay. But it most likely will be the biggest portion of your tax bill every year.
If you want to take the concepts above to the next level and see the effect of taxes on your individual situation, or how taxes would affect a big life decision you are contemplating, we would love to coach you through the process. Head to https://www.financiallyforgotten.com/contactand book a free, 20-minute consultation call with our financial coach (who is also a licensed CPA).