I’ve talked about investing for a bit now. But now it is time to talk about taxes. And one aspect of investing is trying to minimize Uncle Sam’s cut of your investing gains over your lifetime.

I will only be discussing federal taxes, but many of the concepts described here apply to state income taxes as well.

First some acronyms and definitions.

Acronyms:

AGI:Adjusted Gross Income

MAGI: Modified AGI

MFJ:Married filing jointly

FICA:Federal Insurance Contributions Act

Terminology:

Gross income: Income before taxes.

Adjusted Gross Income (AGI): The figure on the bottom of your 1040. It is your gross income minus what are denoted as “above the line” deductions, such as student loan interest, educational expenses, and traditional IRA contributions.

Modified AGI: Your AGI, but adding back certain deductions and income. What gets added back changes based on context.

Standard Deduction:A quantity that may be subtracted from your AGI in order to calculate your taxable income (you either use your standard or itemized deductions – explained later). If you cannot be claimed as a dependent, then you get the full value of the standard deduction ($6200 for single people for the 2014 tax year).

Itemized Deduction:Instead of claiming the standard deduction, you can use certain expenses as your deduction.

Exemption: Each exemption is worth a fixed amount ($3950 for the 2014 tax year). You get an exemption for yourself, so long as you cannot be claimed as a dependent, and each of your dependents. Exemptions are subtracted from your AGI in order to calculate your taxable income.

Taxable income:Your AGI minus your deduction and exemption. This is the quantity used to assess your tax.

Tax withholding:Amount of money withheld by your employer from your paycheck on the behalf of the IRS. The IRS views this as a payment of your income tax bill for the year.

Total tax: Term used by the IRS as the amount of tax incurred from your taxable income, less nonrefundable tax credits.

Tax liability:Amount of tax incurred.This has nothing to do with your tax withholding. This includes any refundable and nonrefundable tax credits (some people may not agree with this last part, but this is the definition I will use).

Tax refund: Amount of money returned to you when your total tax payments – your withholding and any estimated tax payments – are more than your tax liability.

Tax deduction: A reduction of your income subject to tax.

Tax credit:A reduction of your tax liability.

Refundable tax credit: A tax credit that can reduce your tax liability to be negative (and hence, will trigger a tax refund).

Nonrefundable tax credit:A tax credit that can drop your tax liability to zero.

Take home pay: Amount of your paycheck that hits your bank account. This is your gross income, minus tax withholding, 401k contributions, health insurance payments, etc. (Some people may use a different definition, but this is the one I will use).

Marginal tax rate: The rate at which an additional dollar of income would be taxed.

Average tax rate:Your total tax liability divided by your gross income.

Dependent: While the details of who qualifies as a dependent are fairly long, the most common cases are a child under age 19 at the end of the tax year, or a child under 24 at the end of the tax year who is also a student. In both cases, the child can not have provided over half of his or her own support for the tax year. You can find the full definition here.

Net income:Income after taxes (subtract your tax liability, not your withholding, from your gross income).

When attempting to minimize your taxes over your lifetime, we are only concerned about your tax liability, not your tax withholding (to the extent that your withholding is sufficient to avoid any penalties for underpayment of taxes – more on that later).

To explain income taxes, I’ll use an analogy that I’ve seen before on Emily’s blog (and I’m sure others have made this analogy as well) – but there’s a nice extension to capital gains taxes that I haven’t seen elsewhere (I’ll post this later, probably tomorrow). For this scenario, assume that Bob made $80,000 from his job, and has no other source of income. He is single, and has no children. He lives in a state such as Washington that has no personal income tax, and does not have a mortgage. Thus, he does not itemize his deductions (more on itemization of deductions later in the post). To calculate the taxes on this income, imagine filling a bucket with water. Bob pours in $80,000 worth of water. The US tax system is progressive, so the more money Bob earns, the higher the rate at which his The bottom $6200+3950 is not taxed because of the de facto 0% tax bracket created by the standard deduction and exemption (these two quantities are subtracted from your AGI to form your taxable income). The next $9075 is taxed at 10%, $27825 at 15%, and the final $32950 at 25%. Hence, his taxes look like
for a total tax of $13318.75. |

For a reference on all the tax brackets and marginal tax rates for the 2014 tax year, Forbes puts out a good reference every year.

A couple key concepts:

The value of a **tax deduction**: Depends on your tax bracket. Suppose Bob can deduct $3000 from his taxes (could be, for example, a capital loss – to be explained later). Because he is reducing his AGI and hence his taxable income by $3000, the value of the deduction is 25% * $3000 = $750.

The value of a **tax credit**: A tax credit reduces your tax liability dollar for dollar (until the liability hits zero, in the case of a nonrefundable tax credit).

Suppose John earns $30,000, resulting in taxes of $2523.

*Scenario 1*

John had $2100 of tax withholding. He would owe the IRS $423. However, he gets a refundable tax credit of $3000. He is refunded -1*($2523-2100-3000) = $2577.

*Scenario 2*

John had $2500 of tax withholding. He would owe the IRS $23. However, he gets a *non*-refundable tax credit of $3000. His tax liability is reduced to $0. He is still issued a refund of $2500 because he has paid more than his tax liability. Notice how the non refundable tax credit doesn’t exclude him from a tax refund.

### FICA (Payroll) Tax

FICA tax, otherwise known as payroll tax, is used to pay for Social Security and Medicare. FICA tax is only assessed on your *gross wage income*, not on dividends, interest income, etc. The employee pays 7.65% of their income (barring the condition below), and the employer also pays 7.65% of the employee’s income (for self employed people, they are their own employer, so they pay 15.3%). Of that 7.65%, 6.2% is for Social Security and 1.45% is for Medicare. This distinction is important for high earners, as the 6.2% Social Security tax is assessed on the first $117,000 of income (for 2014).

FICA taxes are assessed per person. This is in contrast to income taxes, where for **MFJ, the couple is taxed as one entity.**

FICA tax, unlike income tax, is pretty simple. There are two tax brackets and no deductions (well actually, there is a deduction for HSAs and FSAs – I will discuss them later. But they’re not that big). And it’s unavoidable if you earn money by working.

### Charitable contributions and home mortgage interest are tax deductible right?

Yes, **but only if you itemize your deductions**.

Every year, you have a choice. You can either claim the standard deduction ($6200 for single and $12400 for MFJ for 2014 tax year), or you can itemize your deductions. [In rare situations, you cannot use the standard deduction and hence should itemize- look here for more details. Chances are they don’t apply to you.] The most common deductions are state income tax (or sales tax for those who live in states without income tax), state property tax, home mortgage interest, and charitable contributions [for the full list, look at the IRS instructions]. So if the sum of your itemized deductions is not greater than your standard deduction, then it is pointless to itemize your deductions and you should claim the standard deduction instead. Meaning, if the sum of your other itemized deductions is not large enough you do not realize a tax deduction for charitable contributions, home mortgage interest, etc.

The IRS does let you itemize even if your itemization is less than the standard deduction (though they make you check a box to make sure you realize what you’re doing). So technically, charitable contributions and home mortgage interest are always tax deductible. But that doesn’t mean you’ll actually see your tax liability decrease from those deductions.

### The importance of AGI:

Many tax credits and deductions have exclusions based on AGI. For example, the student loan interest deduction is an above the line deduction for student loan interest paid. Up to the first $2500 of interest is tax deductible. But, if your MAGI is greater than $75000 for single people (or $155000 for MFJ), you cannot claim this deduction. Also, If your MAGI is between $60,000 and $75,000 for single people (or $125,000 to $155,000 for MFJ), then your tax deduction is reduced by a phaseout.

Now in this scenario, your MAGI is your AGI, except adding back the deductions found below the student loan interest deduction on the 1040, and also some other things that don’t apply to most people (exclusion of income by residents of US territories (not states) and foreign income and housing exclusion and deduction). So if you make too much, student loan interest is not tax deductible! But, armed with this knowledge, you can plan ahead! A 401k contribution, for example, will reduce your AGI (I’ll explain 401ks within a couple posts).

Remember, your eligibility for tax deductions and credits are tied to your AGI, **not** your taxable income. Therefore, **while** **donations to charity are tax deductible and reduce your tax liability, they ****do not lower your AGI and hence do not help you qualify for tax deductions and credits with a (M)AGI limit**.

### Do not rejoice when you get a fat tax refund

This infuriates me to no end. There are even “tax refund sales” during tax season to encourage people to spend their tax refunds. This is completely backwards!!! A tax refund represents **money you already earned last year and loaned interest free to the government**. This means you could have adjusted your W-4 (tax withholding form) and gotten the amount of your tax refund paid to you throughout all of last year. If you have debt, such as a typical 6.8% student loan, you could’ve gotten a 6.8% return on that money! If you don’t have debt, you would probably have gotten a much lower return (although who knows—in 2013, the stock market gained ~29%).

Now granted, if you have variable income, it can be difficult to get your tax withholding right. Also, it’s hard to predict the income from your investments. However, if the majority of your income is from a regular paying job, there is hardly any excuse to not getting your tax refund to almost zero.

### Underpayment of Tax Penalty

I think this would be a good time to discuss the five ways you can avoid a penalty for underpayment of taxes (I’ve quoted the 2013 tax year publication):

Generally, you will not have to pay a penalty for 2013 if any of the following apply.

- The total of your withholding and timely estimated tax payments was at least as much as your 2012 tax. (See Special rules for certain individuals for higher income taxpayers and farmers and fishermen.)
- The tax balance due on your 2013 return is no more than 10% of your total 2013 tax, and you paid all required estimated tax payments on time.
- Your total tax for 2013 (defined later) minus your withholding is less than $1,000.
- You did not have a tax liability for 2012.
- You did not have any withholding taxes and your current year tax (less any household employment taxes) is less than $1,000.

From a mathematical perspective, the optimal amount of withholding is the minimum allowed that would still allow you to avoid a penalty via one of the ways above. This optimal amount is always at most $1000 less than your tax liability because of bullet 3 above. By withholding the optimal amount, the US government would be *giving you an interest free loan*.

However, I wouldn’t do this, as you may miss and end up owing a penalty. If your income is reasonably predictable, I would recommend following your best guess and shooting for a tax refund of zero. That way, you have a $1000 buffer to avoid penalties (which is actually a pretty good buffer, depending on your marginal tax rate – at the 25% bracket, that $1000 buffer is good for an unanticipated $4000 of income). If your income is not so predictable, then I would shoot for a small refund.

If you guys think these posts are just too long, let me know.

I think my next post will be on capital gains taxes.

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Nope your blog lengths are just fine. I enjoy the details.

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