Chapter 1

Understanding the Taxes You Pay

IN THIS CHAPTER

Knowing your total taxes

Seeing how marginal tax rates work

Understanding the term taxable income

Being aware of the alternative minimum tax

Staying informed about current tax laws

Taxes are probably one of your largest — if not the largest — expenditures. The goal of this chapter is to help you legally and permanently reduce your total taxes. Understanding the tax system is the key to reducing your tax burden — if you don’t, you’ll surely pay more taxes than necessary. Your tax ignorance can lead to mistakes, which can be costly if the IRS and state government catch your underpayment errors. With the proliferation of computerized information and data tracking, discovering mistakes has never been easier.

Focusing on Total Taxes

Instead of focusing on whether you’re going to get a refund when you complete your annual tax return, concentrate on the total taxes you pay.

To find out the total income taxes you pay, you need to get out your federal and state income tax returns. On each of those returns is a line that shows the total tax you owed for the year: If you add up the totals from your federal and state income tax returns, you’ll probably see one of your largest expenses.

Some people feel lucky when they get an income tax refund, but all a refund really indicates is that you overpaid your income taxes during the year. You should have had this money in your own account all along.

If you’re consistently getting big income tax refunds, you need to pay less tax throughout the year. Fill out a W-4 to determine how much you should be paying in taxes throughout the year. You can obtain a W-4 through your employer’s payroll department or from the IRS.

If you’re self-employed, you can obtain Form 1040-ES by calling the IRS at 800-TAX-FORM [800-829-3676] or visiting its website at www.irs.gov. The IRS website also has a helpful withholding calculator at www.irs.gov/individuals/tax-withholding-estimator.

The tax system, like other public policy, is built around incentives to encourage desirable behavior and activity. For example, saving for retirement is considered desirable because it encourages people to prepare for a time in their lives when they may be less able or interested in working so much and when they may have additional healthcare expenses. Therefore, the tax code offers all sorts of tax perks to encourage people to save in retirement accounts.

It’s a free country, and you should make choices that work best for your life and situation. However, keep in mind that the fewer desirable activities you engage in, the more you will generally pay in taxes. If you understand the options, you can choose the ones that meet your needs as you approach different stages of your financial life.

Recognizing the Importance of Your Marginal Tax Rate

When it comes to taxes, not all income is treated equally. This fact is far from self-evident. If you work for an employer and earn a constant salary during the course of a year, a steady and equal amount of federal and state taxes is deducted from each paycheck. Thus, it appears as though all that earned income is being taxed equally.

In reality, however, you pay less tax on your first dollars of earnings and more tax on your last dollars of earnings. For example, if you’re single and your taxable income (see the next section) totals $50,000 during 2024, you pay federal tax at the rate of 10 percent on the first $11,600 of taxable income, 12 percent on income between $11,600 and $47,150, and 22 percent on income from $47,150 up to $100,525.

Table 1-1 gives federal tax rates for singles and married households filing jointly.

TABLE 1-1 2024 Federal Income Tax Brackets and Rates

Your marginal tax rate is the rate of tax you pay on your last, or so-called highest, dollars of income. A single person with taxable income of $50,000 has a federal marginal tax rate of 22 percent. In other words, they effectively pay 22 percent federal tax on their last dollars of income — those dollars in excess of $47,150.

Marginal tax rates are a powerful concept. Your marginal tax rate allows you to quickly calculate the additional taxes you’d have to pay on additional income. Conversely, you can enjoy quantifying the amount of taxes you save by reducing your taxable income, either by decreasing your income or by increasing your deductions.

As you’re probably already painfully aware, you pay not only federal income taxes but also state income taxes — that is, unless you live in one of the handful of states (Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, and Wyoming) that have no state income tax. Note: Some states don’t tax employment income but do tax certain investment income: New Hampshire (dividend and interest income) and Washington (capital gains income).

Your total marginal rate includes your federal and state income tax rates (not to mention local income tax rates in the municipalities that have them).

You can look up your state income tax rate in your current state income tax preparation booklet or on the website for the state agency that collects income tax for your state.

Defining Taxable Income

This book explains strategies for reducing your taxable income. Taxable income is the amount of income on which you actually pay income taxes. The following reasons explain why you don’t pay taxes on your total income:

• Not all income is taxable. For example, you pay federal income tax on the interest you earn on a bank savings account but not on the interest you earn from municipal bonds. Some income, such as from stock dividends and long-term capital gains, is taxed at lower rates.
• You get to subtract deductions from your income. Some deductions are available just for being a living, breathing human being. In 2024, single people get an automatic $14,600 standard deduction, and married couples filing jointly get $29,200. (People over age 65 and those who are blind get a slightly higher deduction.) Other expenses, such as mortgage interest and property taxes, are deductible (subject to limitations) if these so-called itemized deductions exceed the standard deductions. When you contribute to qualified retirement plans, you also effectively get a deduction.

Part 4 discusses ways to reduce small business taxes.

Being Mindful of the Second Tax System: Alternative Minimum Tax

You may find this hard to believe, but a second tax system actually exists (as if the first tax system weren’t already complicated enough). This second system may raise your taxes even higher than they would normally be.

Over the years, as the government grew hungry for more revenue, taxpayers who slashed their taxes by claiming lots of deductions or exclusions from taxable income came under greater scrutiny. So the government created a second tax system — the alternative minimum tax (AMT) — to ensure that those with high deductions or exclusions pay at least a certain percentage of taxes on their incomes. In its early years of existence, the AMT affected less than 1 percent of taxpayers, but that number greatly expanded over the decades until it impacted 5 million taxpayers. The Tax Cuts and Jobs Act, which took effect in 2018, reduced the impact back down to its original intent of just a few hundred thousand higher-income taxpayers. However, those newer rules are scheduled to expire after 2025, at which time the AMT could hit upwards of 7 million taxpayers.

If you have a lot of deductions or exclusions from state income taxes, real-estate taxes, certain types of mortgage interest, and passive investments (for example, rental real estate), you may fall prey to AMT. You may also get tripped up by AMT if you exercise certain types of stock options or if you have a high amount of capital gains relative to your other ordinary income.

AMT restricts you from claiming certain deductions and requires you to add back in income that is normally tax-free (like certain municipal-bond interest). So you have to figure your tax under the AMT system and under the other system and then pay whichever amount is...