Ch. 22:  Advanced Income Taxes

A video.  Never as good as the text, but this content is confusing, so the video might help.

22.0 Introduction

            I’ve been lying to you.  Please forgive me.  Way back in Chapter 3, I introduced you to the US income tax system.  But I kept things simple and shielded you from the more complex considerations like deductions and tax credits.  This was necessary.  To fully understand the income tax system, one must also have a passing knowledge of tax shelters, health insurance, investment taxes, and so on.  Now you’re ready.

            In this chapter, you will learn the entire sequence that begins with total income and ends with a tax bill.  As with all topics in this class, we should view these steps as merely the rules of the game.  You and I have no control over these often silly rules and regulations, but we need to intimately understand the process so that we can optimize our tax planning and live a good life.  With practice, I think you’ll discover that it’s not so hard!  By the end of this chapter, you’ll know more about the tax system than just about everyone around you.  And this knowledge should prove useful in building wealth.  As we matriculate through the steps, we will use a fictional character (“Amie”) as a case study.  That’s a good start.  But you will need to complete the practice problems to gain a keen understanding of the content.

Step 1:  Total Income

  To begin the process, we must first consider all income earned by an individual (or couple, if filing jointly).  This is nothing new for us, but let’s make sure we include all relevant earnings.  Here are four common sources of income:

This is obviously not an exhaustive list as there are many possible income sources.  Back in 2023, I won some serious moolah playing fantasy sports—these earnings were included in my 2023 income even though they don’t fall into any of the four categories stated above.  The summation of all relevant earnings is called total income and is the necessary first step in the tax calculation process.

            This first step will (usually) only include plus-signs.  You are adding-up all income sources, not yet subtracting relevant content like traditional 401(k) contributions.  These subtractions begin in step 2.

Amie is attractive and succesful, but she's not real.  Sorry.  Amie was AI generated here.

Step 2:  Gross Income

            Once total income is calculated, we begin chipping away at this value with various subtractions and deductions.  While many of these subtractions ultimately affect taxes in the same way, it is imperative that we follow the order of operations as each step in this process is important.  To solve for gross income, we need to subtract all employee paycheck deductions. For example, in 2023, I paid about $6,000 in health insurance premiums through my employer-provided health insurance plans.  This $6,000 is subtracted from my total income when solving for gross income.

            Be careful!  The reductions included here are strictly those that are a result of paycheck deductions such that the income was never realized by the employee.  When I paid my health insurance premiums, I never had a chance to earn this income—the money was directly paid by my employer to my insurance provider on my behalf without my greasy palms ever touching it.  As a comparison, consider a person that has private health insurance that is not connected their employment.  In this case, the person earns the money first, then pays for health insurance out-of-pocket.  This is not a paycheck deduction and would not be included in the calculation for gross income.  Similarly, traditional IRA contributions are not paycheck deductions.

            Furthermore, not all paycheck deductions are relevant to taxes, so it’s necessary to understand how tax laws are applied.  I pay $25/month for a parking pass and $40/month for life insurance via paycheck deductions.  Both expenses are deducted from my salary, but they do not reduce my taxable income.  Here is a list of common paycheck deductions that do reduce taxes.  But remember that these are only relevant if paid via paycheck deduction.

Thankfully, you won’t need to make these deductions yourself.  Your employer is taking care of both the paycheck deductions and the effects they have on your taxes.  Nonetheless, to make good financial decisions, you need to understand this process.

Step 3:  Adjusted Gross Income (AGI)

            The first two steps are quite simple.  In step 1, we simply summed all relevant earnings to solve for total income. Then, in step 2, we subtracted all relevant paycheck deductions to solve for gross income.  Things get a bit messier in step 3, where we solve for adjusted gross income (AGI).

            AGI is found by subtracting above-the-line deductions from gross income.  Above-the-line deductions are a host of lucrative tax deductions that are permitted by the federal government.[1]  Some of these are already known to us.  For example, if you make traditional IRA contributions, these contributions are not made via paycheck deductions, but reduce your taxes nonetheless via an above-the-line deduction.  Similarly, if you pay health insurance premiums to an insurer that is not employer-sponsored, then your tax break will be assigned above-the-line.  Because your employer has no role in these deductions, you must play an active role to ensure all above-the-line deductions are included when you file your tax return.

There are many important above-the-line deductions to consider.  Here are a few of the most common ones:


Rules regarding above-the-line deductions change frequently, so be prepared to reassess your situation every year.  The IRS website is updated frequently (Credits and deductions for individuals | Internal Revenue Service (irs.gov)) but the information isn’t easily digested.  I will keep this list (above) up to date… I got you fam. 

            Mathematically, there is nothing difficult about above-the-line deductions.  Gross income minus above-the-line deductions equals AGI.  One you have solved for AGI, you can move on to the next step.  But, AGI is important beyond just this step.  AGI determines eligibility for various credits and other benefits.  Back in 2021, the government distributed stimulus checks to taxpayers.  To receive the maximum stimulus amount, a single person must have an AGI below $80,000.  AGI is also a determinant of eligibility for child tax credits, dependent card credits, and Roth IRAs.[3]  Thus, it’s key that you understand these steps in order.  If you find that your AGI is too high to be eligible for a lucrative tax break, you can reduce your AGI through various means (e.g. traditional contributions).

Step 4:  Taxable Income

            Following AGI, taxpayers now consider a second round of deductions—itemized deductions.  Unlike standard deductions, itemized deductions (sometimes called “below the line deductions”) are potential deductions.  Why?  Taxpayers have the option to take the standard deduction or itemize.  Before we discuss this decision, let’s first look at the common potential itemizations one can take:

·       Mortgage Interest

o   Mortgage interest on the first $750,000 of a home loan are itemizable.  Keep in mind that this is interest only.  Repayment of principle is not deductible.

·       State and Local Tax

o   Up to $10,000 in state taxes (such as income taxes) and local taxes (like property taxes) are deductible.  As a result, individuals that live in a state with a high state income tax rate are more likely to itemize than those living in a no income tax state like Florida.

·       Charitable Contributions

·       Medical and Dental Expenses

o   These expenses are only deductible if they exceed 7.5% of your AGI (yet another reason why we need to solve for AGI).  If your AGI is $100,000 and you have $10,000 in medical expenses in 2024, only $2,500 will serve as an itemization.

There are plenty more (Credits and deductions for individuals | Internal Revenue Service (irs.gov)) but most others are quite niche.  If you’re single, you have the option of taking your itemized deductions or you may elect to take the standard deduction of $14,600.[4]  For example, suppose you sum your itemizations and find that you only have $9,000.  Thus, you have two options—take a $9,000 deduction (itemize) or take $14,600 (standardized).  Obviously, you will take the larger deduction, which is, in this case, the standard deduction.  For a couple that is married, filing jointly, the standard deduction is twice as large ($29,200).[5]

            About 90% of American taxpayers opt for the standard deduction.[6]  Younger individuals are even more likely to do so.  As one ages and their income rises, the likelihood of itemization rises since those with higher incomes typically have greater state and local tax bill, a more expensive mortgage, and greater charitable contributions.  The frequency of itemizing is also a function of economic conditions—when interest rates are high, mortgage interest costs follow suit.

            Although you are unlikely to itemize in 2024, expect significant changes in the future.  Back in 2018, the Donald Trump-sponsored “Tax Cuts and Jobs Act” increased the standard deduction from $6,350 to $12,000.  This changed the tax game dramatically, cutting the frequency of itemization by about two-thirds.  This supersized standard deduction is set to expire after 2025, so the future of deductions is quite murky.  Such is life in the personal financial planning space.  You have no choice but to stay connected to changes in policies.  Subscribe to my newsletter (feature added soon) and I’ll make sure you get the news you need.[7]

            For me, the choice of itemizing vs. taking the standard deduction is easy.  My wife and I have about $16,000 in potential itemization in 2024, which is far below the standard deduction of $29,200.  Thus, we take the standard deduction.  AGI minus this deduction solves for our taxable income. 

            As an important aside, let’s consider a very common scenario for many college students—what is you earn less than the standard deduction.  For example, consider a single college student who earns $10,000 working during the summer.  Once the standard deduction is applied, this person is left with a negative taxable income, specifically, their tax income is -$4,600.  If this occurs, the person simply owes $0 in taxes.  Typically, this person is not required to file a tax return.  But, there are often reasons to do so anyway.  For example, their employer may have withheld taxes during the year.  All of this paid taxes is due back to the employee via a tax return.  There are plenty of other reasons why you might need to file, such as those discussed here (Do I Have to File a Tax Return if My Income is Less than the Standard Deduction? - Joan Halter CPA).  Furthermore, some workers are eligible for specific tax credits that are refundable in nature, which actually can result in negative tax bill!  This concept is discussed later in the chapter. 

Step 5:  Taxes without Credits

            In step 4, we solve for taxable income.  This is a critically important value in the tax planning process.  Your taxable income shows you where you are on the income tax brackets and also determines your capital gains tax situation.  For example, suppose that you are single and expect to earn an income of $68,000 from your day job, which is your only source of income.  Without investigation, it’s unclear which tax bracket you are in!  Many mistakenly use this $68,000 in total income and surmise that they are in the 22% bracket.  But you are wise and know that you must complete steps 1-4 to solve for your taxable income, which you find is equal to $40,500.  Applying the table below…

…you discover that you are firmly in the 12% marginal tax bracket.  Why does this matter?  As a 12%’er, you are clearly incentivized to choose Roth investments.  By analyzing your tax situation, you can make the proper investment choices, which should serve to increase your net worth significantly as you approach retirement.  But that’s not all, with $40,500 in taxable income, you are now able to assess your capital gains situation.  Consider the table below:

With $40,500 in taxable income, you are in the 0% capital gains bracket.  This means you could earn up to $6,525 in capital gains (qualified dividends or long-term stock profits) without paying any taxes.  So, at the end of 2024, you might choose to intentionally sell profitable stocks in your brokerage account to trigger a taxable event that creates no taxes!  This is a real-life strategy called tax gain harvesting that many employ.[8]  Only those that understand the tax planning steps can take advantage.

            Okay, so taxable income is important.  What next?  To move to the next step in our federal tax planning process, we merely to employ the tax brackets that we have used many times in this class (but now we are using the correct value!).  Taxable income is applied to the tax brackets.  The value that the brackets spit-out is called taxes without credits. 

Step 6:  Income Taxes (Last step!)

            In the previous step, we solve for taxes without credits.  To complete our journey, we now need to apply tax credits.  While tax deductions reduce taxable income, a tax credit directly reduces one’s tax bill.  As such, tax credits are dollar-for-dollar, more valuable.  For example, consider the usefulness of the three deductions/credits below:

1.       $1,000 above-the-line deduction

2.       $1,000 potential itemization (below-the-line deduction)

3.       $1,000 tax credit.

For our sakes, let’s assume the individual above is in the 22% bracket and does not itemize, which is a typical scenario for a college graduate in the middle of their career.  How much are these deductions/credits worth?  The $1,000 above-the-line deduction is worth exactly $220: This deduction reduces taxable income by $1,000 and taxes $220, since they are in the 22% bracket.  The $1,000 potential itemization is worth nothing!  The individual is not itemizing, so they receive no tax break from this potential itemization.  And finally, the $1,000 tax credit is worth $1,000.  A tax credit doesn’t reduce taxable income, it reduces taxes, which is far more valuable.

            The most common tax credit in the United States is the child tax credit.  In 2024, having a child (ages 0 to 16) generates a $2,000 tax credit for the caretaker(s), usually a parent or parents.  And this credit is applied per child, meaning that a married couple with three children receive a $6,000 tax credit.  Here is a short list of other popular tax credits available in the United States:

As can be inferred from the information above, these credits are often extremely complex.  So, if you think you may be eligible, it’s going to take some effort to determine if you truly are, and if so, how much the credit is worth. 

            While I won’t discuss all of these at lengths, I think it’s a useful exercise to carefully investigate at least one of these to give you an idea of how credits are applied.  Let’s take a look at the saver’s credit[9], which is frequently useful for recent college graduates.  This credit is designed to incentivize low-ish income individuals to contribute to retirement accounts.  Specifically, a person within the proper AGI window can unlock the saver’s credit by making contributions to 401(k), 403(b), 457(b), and IRA accounts—contributions can be traditional or Roth.[10]  The maximum eligible contribution amount is $2,000 (single) or $4,000 (married, filing jointly).  The size of the credit received is based on one’s AGI, per the table below.

  So, imagine you graduate from college, are single, and earn an AGI of $23,500 in 2024.  Now, that might sound like an artificially low income, but remember that this is AGI, not total income.  Furthermore, recent grads often begin their first full-time job midway through a calendar year.  A person earning a $60,000 salary is only going to realize $30,000 in total income if they begin in early July.  So, your $23,500 AGI is totally reasonable. 

  If you don’t make any retirement contributions, there would be no saver’s credit.  But, if you contribute, say, $5,000 to a Roth IRA in 2024, you are now eligible!  Of this $5,000 contribution, $2,000 is an eligible contribution for the saver’s credit.  Using the table above, your AGI of $23,500 places you in the 20% credit rate category.  Thus, 20% of your $2,000 eligible contribution, or $400, is awarded via tax credit.  You will save $400 in taxes in 2024, usually via an increased tax return. 

  You might consider getting creative to generate an even larger credit.  What if you reconsidered your retirement contributions and decided to allocated $4,400 to a Roth IRA and $600 to a traditional 401(k)?  Now, your AGI is $22,900 and you have sneakily moved into the 50% credit rate category!  You still have $2,000 in eligible contributions, but your credit is now $1,000![11]  Through diligent planning and a keen understanding of tax law, you have just manufactured significant tax savings.

  But the rules regarding eligibility for the saving’s account are not simply a result of AGI.  What if the saver’s credit results in a negative tax bill?  For example, consider a single person who has contributed $2,000 to a Roth IRA, has  an AGI of $20,000 and a taxes without credits value of $200.  Using the table above, this person should be eligible for a $1000 tax credit.  However, if we apply this credit, the individual now has a -$800 tax bill?  Verbatim, this means the person pays a negative tax, or, put another way, is given money by the government.  Is this allowed?  For the saver’s credit, it’s unfortunately not.  The saver’s credit is not refundable, which means that the credit cannot result in a negative tax bill.  But, some credits are fully refundable (the credit is fully available even if it results in negative taxes) or partially refundable (the credit can generate negative taxes, but the size of the credit is smaller once the tax bill becomes negative). 

  This is all such a big mess, isn’t it?  Anyway, once the tax credits have been applied, we have reached the final step and can solve for one’s tax bill.  Let’s see how Amie made out:

As is indicated by Amie’s very typical financial situation, the actual tax bill that many Americans face is a lot lower than is typically assumed by the general public.  You’ve probably heard someone say something like, “The government takes a third of my money.”  That’s possible but quite unusual, even after factoring in Social Security and Medicare taxes.  For Amie, who earned $86,000 in total income and paid $5,012 in income taxes, her effective tax rate for income taxes is only 5.83%. 

Conclusions

            From my experience, very few individuals have a solid understanding of the income tax system.  If you understand everything covered in this chapter, this probably puts you in the top 5% in tax literacy among Americans.  But there is always more to learn.  Despite years of learning, I still feel like a neophyte when it comes to this stuff.  If you want to make optimal decisions, you’ll need to plan to learn the tax rules and adapt to new changes.  And if you actually like this material, maybe should be in accounting.  Those folks get paid the big bucks for a reason!

 

Case Study for a Typical Person

Desiree is single and earns $51,000 from her job.  She also earns $5,000 in ordinary dividends and $8,000 in qualified dividends (both in taxable accounts).  She makes $5,000 in Roth IRA contributions, $4,000 in traditional 457(b) contributions, and $1,500 to her HSA.  She pays $4,000 for health insurance, which is provided through her employer.  In 2024, she makes $8,000 in student loan repayments, of which $1,000 is contributed to interest.  She has $8,000 in potential itemizations and has two kids, aged 15 and 19.  Solve for her federal income taxes, capital gains taxes, Social Security taxes, and Medicare taxes.  Assume that this information is comprehensive (there is no omitted relevant information).

Income Taxes

Total Income = $51,000 + $5,000 = $56,000

·       Included employment income and ordinary dividends.

Gross Income = $56,000 - $4,000 - $1,500 - $4,000= $46,500

·       Subtracted paycheck deductions.

AGI = $46,500 - $1,000 = $45,500

·       Subtracted above-the-line deductions, which in this case is interest paid on a student loan. 

Taxable Income = $45,500 - $14,600 = $30,900

·       Apply the standard deduction since the potential itemizations are less than the standard deduction.

Taxes Without Credits = $3,476

·       Apply the tax brackets to taxable income.

Income Taxes = $3,476 - $2,000 = $1,476

·   She gets a $2,000 deduction for the 15 year-old, but nothing for the 19 year-old.  Her AGI is too high to receive a saver’s credit.

Capital Gains Taxes

Capital Gains Taxes = $0

·   While Desiree has $8,000 in capital gains, her taxable income is only $30,900.  Thus, her combined taxable income and capital gains is only $38,900.  She is in the 0% capital gains tax bracket.

Social Security Taxes

Social Security Income = $51,000 - $4,000 - $1,500 = $45,500

·   Social Security only considers employment income for earnings.  Desiree’s contributions to her HSA and her health insurance premiums reduce her Social Security Income.

Social Security Taxes = $45,500(0.062) = $2,821

Medicare Taxes

Medicare Income = $51,000 - $4,000 - $1,500 = $45,500

·   Always the same as Social Security income.

Medicare Taxes = $45,500(0.0145) = $659.75

End Notes


[1] The stupid name, above-the-line, derives from the location of these deductions on tax forms. 

[2] I hired an accountant back in 2017 to complete my taxes.  She assigned a $300 deduction for educator expenses even though I’m not a K-12 teacher (sorry about the mistake, IRS).  She also royally bungled the tax handling of a house sale.  What a hack.  If you want something done right, do it yourself.

[3] Roth IRA is based on Modified AGI.  If a single person’s modified AGI exceeds $146,000, they are not fully eligible to contribute to a Roth IRA.  If you think this may be relevant to you, learn more here and give me some money, you rich rascal.

[4] There are separate rates for those over age 70 and the blind.  I won’t bother discussing those here, but make note if this is relevant to you.

[5] The standard deduction for heads of household is $21,900.  For those married, filing separately, the standard deduction is $14,600.

[6] Source.

[7] Ehh… maybe.  I consider only the rule changes that relevant to lots of taxpayers.  I’m not diving into the weeds, sorry.

[8] Learn more here.

[9] Technically titled the Retirement Savings Contributions Credit.

[10] Note that the 401(a) is absent from the list provided by the IRS, which can be found here: here.  Articles online state that 401(a) contributions might be eligible.  So, who knows?  HSA and other health spending accounts are not treated as retirement accounts and are thusly ineligible.  SARSEP and SIMPLE plans, which are beyond the focus of this book, are eligible.

[11] Normally, a person in the 10% or 12% income bracket should avoid traditional contributions and opt for Roth only.  This is an exception to that general rule.  

Practice Problems

a.       Solve for their income taxes.  Show your steps.

b.       Solve for their capital gains taxes.

c.       Solve for their Social Security taxes.         

d.       Solve for their Medicare taxes.

e.       It’s December of 2024, so they still have some time to make some adjustments to their situation.  If they were to suddenly contribute $5,000 to a traditional IRA, how much would this save them in federal income taxes?

a.       Solve for their income taxes.  Show your steps.

b.       Solve for their capital gains taxes.

c.       Solve for their Social Security taxes.         

d.       Solve for their Medicare taxes.

e.       It’s December of 2024, so they still have some time to make some adjustments to their situation.  They decide to contribute $3,500 more to a traditional 401(k).  Re-solve for their income taxes now.  How much income taxes did they save by making this $3,500 contribution?

a.       Solve for their income taxes.

b.       It’s December of 2024, so they still have some time to make some adjustments to their situation.  They decide to contribute $10,000 to a traditional 401(k).  Re-solve for their income taxes now.  How much income taxes did they save by making this $10,000 contribution?

Solutions

Total Income = $105,000

Gross Income = $105,000 - $5,000 = $100,000

AGI = $100,000 - $3,500 = $96,500

Taxable Income = $96,500 - $18,000 = $78,500

Taxes Without Credits = $10,373

Income Taxes = $10,373


Total Income = $81,000 + $2,000 = $83,000

Gross Income = $83,000 - $6,000 = $77,000

AGI = $77,000 - $6,000 = $71,000

Taxable Income = $71,000 - $29,200 = $41,800

Taxes Without Credits = $4,552

Income Taxes = $4,552 - $2,000 - $400 = $2,152

 

a.       Solve for their income taxes.  Show your steps.

Total Income = $122,000

Gross Income = $122,000 - $6,500 - $2,000 - $20,000 = $93,500

AGI = $93,500 - $14,000 = $79,500

Taxable Income = $79,500 - $14,600 = $64,900

Taxes Without Credits = $9,331

Income Taxes = $9,331 - $1,500 = $7,831

b.      Solve for their capital gains taxes.

Capital Gains = $22,000

Given their taxable income of $64,900, they are in the 15% bracket

Capital Gains Taxes = $22,000*0.15 = $3,300

c.       Solve for their Social Security taxes.    

SS Income = $122,000 - $6,500 - $2,000 = $113,500

SS Taxes = $113,500*0.062 = $7,037

d.      Solve for their Medicare taxes.

Medicare Income = $122,000 - $6,500 - $2,000 = $113,500

Medicare Taxes = $113,500*0.0146 = $1,645.75

e.       It’s December of 2024, so they still have some time to make some adjustments to their situation.  If they were to suddenly contribute $5,000 to a traditional IRA, how much would this save them in federal income taxes?

With a taxable income of $64,900, they are in the 22% income tax bracket.  So, they will save $0.22 in taxes for ever dollars of reduced taxable income.  This $5,000 traditional IRA contribution reduces taxable income by $5,000. $5,000*0.22 = $1,100

a.       Solve for their income taxes.  Show your steps.

Total Income = $72,000 + $5,500 = $77,500

Gross Income = $77,500 - $6,000 - $5,000 - $10,000 = $56,500

AGI = $56,500 - $8,500 = $48,000

Taxable Income = $48,000 - $29,200 = $18,800

Taxes Without Credits = $1,880

Income Taxes = $1,880 - $800 = $1080

b.      Solve for their capital gains taxes.

Capital Gains = $16,000

Given their taxable income, they are in the 0% bracket.

Capital Gains Taxes = $0

c.       Solve for their Social Security taxes.    

SS Income = $72,000 - $6,000 - $5,000 = $61,000

SS Taxes = $61,000*0.062 = $3,782

d.      Solve for their Medicare taxes.

SS Income = $72,000 - $6,000 - $5,000 = $61,000

SS Taxes = $61,000*0.0145 = $884.50

e.       It’s December of 2024, so they still have some time to make some adjustments to their situation.  They decide to contribute $3,500 more to a traditional 401(k).  Re-solve for their income taxes now.  How much income taxes did they save by making this $3,500 contribution?

Total Income = $72,000 + $5,500 = $77,500

Gross Income = $77,500 - $6,000 - $5,000 - $10,000 - $3,500 = $53,000

AGI = $53,000 - $8,500 = $44,500

Taxable Income = $44,500 - $29,200 = $15,300

Taxes Without Credits = $1,530

Taxes With Credits = $0

 

a.       Solve for their income taxes.

Total Income = $39,000

Gross Income = $39,000 - $2,500 - $3,000 = $33,500

AGI = $33,500 - $1,000 = $32,500

Taxable Income = $32,500 - $14,600 = $17,900

Taxes Without Credits = $1,916

Income Taxes = $1,916

b.      It’s December of 2024, so they still have some time to make some adjustments to their situation.  They decide to contribute $10,000 to a traditional 401(k).  Re-solve for their income taxes now.  How much income taxes did they save by making this $10,000 contribution?

Total Income = $29,000

Gross Income = $29,000 - $2,500 - $3,000 = $23,500

AGI = $23,500 - $1,000 = $22,500

Taxable Income = $22,500 - $14,600 = $7,900

Taxes Without Credits = $790

Income Taxes = $0