25—Lever #2: Taxes (Part Three—Your Tax)
It might be less than you think
In the last article, we learned about gross income (and no, low doesn’t mean gross), adjusted gross income (AGI), and calculating taxable income using the standard deduction. Now, we are ready to do the tax calculations.
Millions of people are doing that right now, for as I write this, we are at the heart of tax season (although they’re probably using some tax software or paying someone to do it for them). I’ve used Intuit’s TurboTax for years, and it has worked well for me.
Before the tax calculation, there’s something else to discuss.
After you do your taxes or have them done, you might have a nice refund or a big surprise. If you're like many young adults, you may be happy getting a big tax refund each year—it feels like "free money." But in reality, it has actually cost you money!
That refund is just the IRS returning the money you overpaid throughout the year. You loaned it to the government interest-free instead of using it to earn interest for yourself. It may not be a lot, but interest is interest—better yours than the government’s.
Remember that in our Financial Life Equation, taxes are a negative, but interest earned is a positive. So, even though you get a "refund," it reduces your current wealth by the interest you could have earned on it.
I’ve highlighted the “minus sum of all taxes paid” (– ∑Tt+n) and the “sum of all interest earned” (+ ∑IEt+n ) elements in the equation.
So, instead of giving the government an interest-free loan, you could adjust your tax withholding to keep more money in your paycheck while ensuring you don’t owe a lot at tax time.
You may recall from the first article in this series on income tax that withholdings from your paycheck reduce your taxable income. In addition to the government payroll taxes, there are the other adjustments and deductions we discussed.
You don’t have control over some of them, like FICA, but you do regarding how much of your paycheck your employer withholds for federal and state taxes. If too much is withheld, you get a refund. If too little is withheld, you may owe money when you file your taxes.
Owing a little money is not necessarily bad, especially if it is sitting in a high-yield savings account. Your earnings can pay a little of the taxes you owe. But if you withheld way too little, the IRS may hit you with a penalty.
If you'd rather not loan the government your hard-earned money, you can adjust your withholding to strike the right balance between what's withheld and what you keep.
One way to do that is to use the IRS Tax Withholding Estimator, available on the IRS website. It helps determine how much tax should be withheld based on income, deductions, and tax credits. It’s the best way to estimate your ideal withholding amount if you don’t want to do the calculations yourself.
If you'd rather do it yourself, the math is pretty simple. For this example, we'll return to our previous article and assume you are single and earn $60,000/year in salary.
First, determine what you’re currently having withheld from your paycheck:
Tax withholding per period x Number of periods = Total tax withheld
For example: $150 x 24 = $3,600
Next, you need to know your taxable income. We calculated that in the last article and came up with $39,500. Now, you can estimate how much tax you’ll actually owe. But before we do, let’s discuss tax brackets and marginal rates.
Our government uses a "progressive" income tax system, which means that the higher your income, the more taxes you will pay (usually—wealthy taxpayers sometimes use sophisticated accounting methods to pay less). There are seven "tax brackets," each for a certain income level and with tax rates ranging from 10% to 37%.
That means some of your income is taxed at 10%, and some is taxed at higher rates—how high depends on your taxable income. This sounds complicated, but it is all about "marginal rates."
Your marginal rate is the amount you pay on your last dollar of taxable income. If only $10 is in the 24% tax bracket, that's your "marginal tax rate." The rest of your taxable income is taxed at a lower rate.
Looking at the tax brackets for 2024 for a single filer will make this clearer:
10% on income up to 11,600
12% on income from $11,601 to $44,725
22% on income from $44,726 to $95,375
24% on income from $95,376 to $182,100
32% on income from $182,101 to $231,250
35% on income from $231,251 to $578,125
37% on income of $578,126 or more
The brackets are adjusted for inflation each year, and for tax year 2025 single filers, they will be as follows:
10% on income up to $11,925
12% on income from $11,926 to $48,475
22% on income from $48,476 to $103,350
24% on income from $103,351 to $197,300
32% on income from $197,301 to $250,525
35% on income from $250,526 to $626,350
37% on income from $626,351 and above
The table is easy to use. For example, someone with a taxable income of $250,000 a year is in the 32% bracket, whereas someone making $25,000 is in the 12% bracket—easy peasy.
Since you know your taxable income ($39,500), we can calculate the tax owed in each bracket. The calculation is as follows:
The first $11,600 is taxed at 10% ($11,600 x 0.10 = $1,160). This leaves $24,300 (=$35,900 – $11,600) still to be taxed.
The next $24,300 is all in the 12 % tax bracket ($24,30 x 0.12 = $2,916).
Thus, the total estimated federal tax owed is ($1,160 + $2,916 = $4,076).
Here it is shown graphically:
This graphic illustrates the progressive tax structure, even for relatively low levels of taxable income. Starting with our taxable income from the bottom up, we see that the first $11,600 is taxed at 10% ($1,160), but then the next $24,300 is taxed at 12% ($2,916). Total tax is $4,076.
If taxable income exceeds $47,150, the next $53,375, up to $100,525, or any portion, would be taxed at 22%. And so it goes as you work your way up the tax bracket ladder. Looking back at the tax brackets, you’ll see that the highest “steps” on the ladder are 12% to 22% (a 12% increase) and 24% to 32% (an 8% jump). Keep that in mind as we discuss other topics in the future.
Now we know your tax owed, but we're not quite through. You may be entitled to one of several tax credits. Some examples are the American Opportunity Tax Credit (up to $2,500), the Lifetime Learning Credit (up to $2,000), the Energy Efficient Home Improvement Credit (up to $3,200), and the Foreign Tax Credit.
For example, if you're in school, you may qualify for the American Opportunity Tax Credit of up to $2,500. (For 2024, it starts to phase out for single taxpayers who have adjusted gross income between $80,000 and $90,000, so it would apply in our example.)
Subtracting the credit from our tax owed ($4,076 – $2,500 = $1,576).
Even without the credit, your average tax rate is 6.8% of your gross income. Your marginal rate (the tax on your next dollar of earned income) is 12%.
Now that you know how much tax you owe, you can calculate how much should be withheld per paycheck to ensure you don't give the IRS an interest-free loan.
It's straightforward: You divide the tax owed by the total number of paychecks per year. To continue our example,
$1,576 ÷ 24 =$67.00
Next, compare that amount to what we said at the beginning of this article: $150.
($150 – $67.00) = $83.00 in excess withholding, or $996 per year.
Since you’re withholding almost $1,000 a year too much, you can adjust it using your employer's W-4 Form. That’s money you could have contributed to an IRA or 401(k) or given away if you wanted to.
You used to be able to make adjustments by changing the number of “allowances” you claimed. But the newer tax laws did away with that. Now, you have to claim “dependents,” or you can claim other deductions or credits (on line 4b) to decrease withholding or specify extra withholding (on line 4c).
You should also check your withholding after significant life changes. Your tax situation can change due to a new job (different employers withhold differently), a raise (higher income could mean higher taxes), marriage or having kids (these affect your tax credits and deductions), or starting a side hustle (these don't have automatic withholding, so you may need to adjust your W-4 or make estimated tax payments).
No matter what, it’s a good idea to reevaluate your withholding each year. Tax laws and your financial situation change, so check your withholding at least once a year, ideally in early fall. This gives you time to adjust for next year before the year ends.
For reflection: How much thought do you give to the taxes you pay each year? Is it something you do because you have to and want to get it over with? Are you beginning to see that good stewardship includes having at least a general understanding of how the tax system works and using it to your advantage as much as possible? Money legitimately not spent on taxes, even small amounts, can be used for other purposes, including charitable giving.
Verse: “One who is faithful in a very little is also faithful in much, and one who is dishonest in a very little is also dishonest in much” (Luke 16:10, ESV).