Federal Individual Income Tax — A Primer

It’s tax season again, and it’s recently struck me that an awful lot of people don’t really understand how the income tax works, and I’m not talking about the nitpicky details in the thousands of pages of tax codes (nobody understands those, at least not all at once). Some people have never done their own taxes, and even people who are fairly adept at getting their own tax forms filled out and filed correctly have gaps in their understandings which have significant policy and personal finance implications.

Over the course of the year, the IRS peels off a portion of every paycheck based on an estimate of the taxes we’ll owe (we have Milton Friedman and Donald Duck to thank for this). And then, the following Spring, we fill out a bunch of forms to calculate what we actually should have owed, and either send in a check to cover the underwithholding or apply for a refund for overwithholding. From a personal finance perspective, you want to withhold just enough to be confident of avoiding penalties for underwithholding; a big refund is a big interest-free loan to the government.

The first step in calculating your income tax liability is to calculate your income. You add up all your wages, tips, short-term investment income, business and rental profits, etc, and you subtract out your personal exemption; business, rental, and investment losses; contributions to tax-deferred retirement accounts; etc. The number you come up with at the end of this process is your Adjusted Gross Income (AGI). There’s also several numbers called Modified Adjusted Gross Income (MAGI) which you may have to calculate later on to figure out if you’re eligable for deductions and credits which phase out when your income is too high; there are four or five different MAGI, each with its own formula, where you add back in certain things you subtracted out of your AGI.

Next, you calculate your Taxable Income. You have a choice here: you can either add up all the Itemized Deductions you’re eligable for (the big ones for most people are state taxes, mortgage interest, and charitable contributions), or you take the Standard Deduction which is a flat dollar amount based on the number of people in your household. Usually, the standard deduction is higher unless you own a house with a mortgage or you have a large income in a state with high taxes. Whichever number you chose, you subtract from your AGI to yield your taxable income.

Then you add up the taxes you’ve already “paid”. “Paid” is in “scare quotes” because this step includes Tax Credits, which is money the IRS pretends you’ve paid them if you do certain things policymakers like. Once you add up all the taxes you’ve actually prepaid (mostly withholdings, but also quarterly estimated tax payments if you make them (usually only people who own small businesses do this)), you compare this to what you should owe, and you either make a payment or claim a refund.

There are three types of tax breaks:

• Above-the-line deductions reduce your AGI. You can take these whether or not you itemize deductions. The most common examples for most people are investment losses, out-of-pocket business espenses, and contributions to tax-deferred savings (401(k)s, traditional IRAs, and HSAs).
• Below-the-line deductions reduce your taxable income directly, but only if you itemize. Below-the-line deductions are what you take instead of the standard deduction. This is particularly important to remember when calculating the value of a tax break (for example, when buying a house) because you need to subtract out the value of the standard deduction you’re losing from the value of the itemized deductions you’re gaining.
• Tax credits subtract directly from your taxes owed, not your income. If your marginal tax rate is 25%, then $1 in tax credits is worth the same to you as $4 in tax deductions.  They come in two flavors: refundable (which can reduce your tax liability to a negative number) and nonrefundable (which you can only claim up to the amount of taxes you owe).

Many tax breaks (especially tax credits) are limited by Income Phase-Outs. For example, the  2009 first-time homebuyer’s tax credit phases out between a MAGI (in this case, AGI plus untaxed foreign income) of $75,000 and $95,000 for unmarried taxpayers. If your MAGI is $75,000 or below, you’re eligable for the full amount of the credit, but you can’t claim any of it if your MAGI is above $95,000, and if your MAGI is between $75,000 and $95,000 the maximum amount you can claim is reduced 40 cents for every dollar your MAGI exceeds $75,000.

Now, once you’ve calculated what you owe, there are three numbers of particular interst both for public policy discussions and personal finance decisions. I strongly suggest taking the time to calculate these.

• Your Average Tax Rate is simply your total tax liability (taxes owed minus tax credits) divided by your income. You can use your AGI for this for simplicity’s sake, but if your AGI is at all complicated I’d suggest calculating your actual income from a personal finance perspective rather than a tax-law perspective (i.e. what you’d tell the bank your income was if you were applying for a loan). My 2009 average tax rate for the federal income tax was 11.4%.
• Your Tax Bracket is how much your taxes owed changes when you raise or lower your taxable income by a small amount. If you itemize deductions, this represents how much an additional dollar of below-the-line deductions is worth to you. You can find this by taking your taxable income and looking up where it falls on the tax bracket table. My 2009 federal income tax bracket was 25%.
• Your Effective Marginal Tax Rate is how much your taxes owed changes when you raise or lower your AGI by a small amount. This represents how much an additional dollar of above-the-line deductions is worth to you, and how much of a bite was taken from your last dollar of income. My 2009 federal income tax effective marginal rate was 78%. That’s not a typo — I’m in the phase-out range for the First Time Homebuyer tax credit and the ironically-named Making Work Pay tax credit, so I only kept 22 cents of the last dollar I earned last year (only about 10 cents, actually, once I factor in the payroll tax and state income tax as well).

Be sure to repeat these calculations for state taxes and the payroll tax as well. For my state taxes, I had an average tax rate of 5.6%, a tax bracket of 9.8%, and an effective marginal rate of 9.8%. For the payroll tax (not counting the Employer Match — your employer also pays an amount equal to your payroll tax for the privilege of employing you), I had an average rate of 7.1%, and a bracket and effective marginal rate of 1.45% (I’m maxed out on the Social Security portion of the payroll tax, so my last dollar of income only faces the Medicare tax). My total income/payroll rates are average of 24.1%, bracket of 36.25%, and effective marginal of 89.25%.

Most years, my average tax rate is significantly higher and my effective marginal rate is much lower, but buying a house, repairing it, buying appliances, and renting out part of  it gave me rather a lot of one-time tax breaks, but left me with a very steep effective marginal rate due to the phaseouts of some of the tax breaks.