1. Your personal federal and state income tax rate
It’s interesting to see just how much you will pay in income tax based on your annual income. The Tax Foundation does a much better job of explaining this than I can, and they have helpful graphs so check their pages out for federal and state taxes.
2. What “standard deduction” and “personal exemption” mean and how they work
A standard deduction is a set amount of income that you don’t have to pay taxes on, and depends on your filing status. In 2017, this was $6,350 for single people and $12,700 for married people filing jointly.
A personal exemption is also a set amount of income you don’t have to pay taxes on, but this does not depend on your filing status. Everyone gets a personal exemption of $4,050 for 2017.
This means that if a single person made $50,000 in 2017, after the standard deduction and personal exemption, they would only need to pay taxes on $39,600.
3. How to reduce the amount of taxes you pay
The majority of Americans could be paying less in income taxes at their current income levels. Only 10% of 401(k) participants contributed the maximum amount to their 401(k) accounts in 2016, meaning 90% of people could have reduced their taxes by contributing more.
(A 401(k) reduces the amount of taxes you owe, similar to a standard deduction, and your earnings are invested and allowed to grow until you retire. I’ll probably do a full blog post on 401(k) accounts soon)
Using the 2017 rates above, if a single person earning $60,000 per year didn’t contribute to their 401(k) at all, they would pay $8,139 in federal income tax (on $49,600 of taxable income after their standard deduction and personal exemption).
If the same single person earning $60,000 contributed the maximum amount of $18,000 into their 401(k), they would only pay $4,274 in federal income tax (on $31,600 of taxable income after their standard deduction, personal exemption, and 401(k) contributions).
This person in scenario #2 just gave themselves a $4,000 raise by maxing out their 401(k). Not bad!
There are many other ways to reduce your taxes, such as contributing to an Individual Retirement Account, a Health Savings Account, taking advantage of tax credits, and others.
4. What your tax dollars are used for
It’s easy to think that you don’t benefit from paying taxes, as our benefits are often indirect or we won’t see them until we retire. A significant amount of your federal income taxes are used for defense and military (not getting invaded is cool right?), healthcare (not dying of rampant disease is cool right?), and social security (not making Grandpa work is cool right? You’re welcome Grandpa).
After those big three, there is also a certain amount used for infrastructure and transportation (did you use a road today?), education (you’re able to read this right?), and science/medical research (which has given the world lots of cool stuff, including camera phones and wireless headphones, among others).
I can drive a car from my house in Dallas to my hometown in Minnesota 1,000 miles away on roads that I could never pay for myself. At a low estimate of $2 million per mile of interstate highway, those 1,000 miles would cost 2 billion dollars to create. Now those few thousand dollars I pay in taxes doesn’t seem like that much.
5. You have to pay your taxes
At the end of the day, we all want to reduce our tax payment as much as legally possible, but we don’t want to avoid paying the taxes we legally owe. That would not be cool.
#MoneyGoals
(Pictured: The Washington Monument as seen from the Lincoln Memorial, May 2016)