FINANCING LIFE
Fall 2015
Session #3 – Understanding Taxes
Who can forget the shock of receiving the real first paycheck? The harsh reality of the difference between
gross pay and take-home pay is an inescapable component of modern life. Part of being financially sophisticated
is understanding the tax system and how to organize your finances so that you meet your legal obligations while
still minimizing the amount you must pay.
In its simplest form, the income tax system starts by adding up “all income received,” passing it through a
“tax filter” to determine the tax liability and then leaving behind “disposable income.” However, the tax code is
anything but simple. After that initial designation of tax liability, there come several thousand pages of “excepts,
unlesses, & untils.” Tax planning involves understanding all those special provisions and arranging your financial
affairs so that you minimize the amount you legally owe. It principally consists of:
a. organizing income so that some of it doesn’t “count” — exclusions
b. using income in ways that prevent or postpone its passing through the “tax filter” — adjustments such as
contributions to tax deferred retirement plans, deductions that allow expenditures with “pre-tax” rather
than “after tax” dollars, and taking personal exemptions.
c. taking advantage of provisions that return a portion of your taxes to you — tax credits.
THE INCOME TAX STRUCTURE AND YOUR “MARGINAL” TAX RATE
When your taxable income passes through the tax filter it is divided into distinct segments. The first $9,225
(for a single taxpayer) goes into a “box,” and the contents of that “box” are taxed at 10%. If the “box” is just
filled you will owe, $922.50. Into the next box goes any income between $9,225 and $37,450. Income in the
second box is taxed at 15%. You then pay the original $922.50 PLUS 15% of the amount in the second “box”.
There are also higher brackets or “boxes” with rates of 25%, 28%, 33% and 35%. Thus your last dollar is taxed
more heavily than your first dollar, and the rate on the last dollar is known as your “marginal” tax rate. Any dollar
you prevent from passing through the tax filter reduces your tax bill by the amount of the marginal rate. (The
brackets and rates for tax year 2015 are listed at the end of this handout.)
HOW DO YOU PREVENT DOLLARS FROM PASSING THROUGH THE TAX FILTER?
Exclusions:
Some income received doesn’t count when the IRS adds up your Gross Income. Benefits
such as health insurance or child care paid directly by your employer are simply left out. If
you instead receive pay and use that money to buy health insurance it is much more
expensive (you have to pay for the insurance AND pay taxes on the income used to buy it.)
Whenever possible it makes sense to use non-taxable employer benefits to meet important
needs. Your total compensation is more important that your pure “salary.”
Adjustments &
Deductions:
Any expenditure that can be made before your income is subjected to the “tax filter” will
reduce your tax liability. The money is “gone” before it reaches the tax filter. Thus you pay
with complete “pre-tax dollars” as opposed to reduced “after tax dollars.” Contributions to an
IRA or other deferred retirement plan and, for the first five years, interest payments on
student loans are adjustments. Mortgage interest, state and local taxes, excessive medical
costs and charitable contributions are all deductions that reduce taxable income. If you do not
have many such special expenditures you can take a fixed amount, known as the “standard
deduction”—for 2015 that value is $6,300. If you have qualified expenditures above that
threshold you can “itemize.”
Exemptions:
Every individual in a taxpaying unit, (individual, joint, household) is entitled to a personal
exemption, in 2015 worth $4,000. You can “skip” that amount around the tax filter and
pretend you never received it. How much that is worth to you depends, of course, on your
marginal tax rate.
Sponsored by the Center for Women & Financial Independence
FINANCING LIFE
Fall 2015
GETTING SOME BACK
There are a few provisions that can be used to reduce your final tax liability even after your taxable income
has passed through the filter. These are known as tax credits. Childcare expenses for working parents and
adoption expenses, among others, may give rise to a tax credit. Every dollar of a tax credit reduces your tax
liability by one dollar. A tax credit is of equal value to all qualified taxpayers, regardless of their individual
marginal rate.
There are a few exceptions to the general rule of trying to pay expenses with pretax dollars. For example, if you
pay disability insurance premiums with pretax dollars, any benefits received will be taxed. However it the
premiums are paid with after tax dollars, the IRS considers any benefits received to have already been taxed.
OTHER TAXES
And then of course there are state income taxes, social security taxes, Medicare taxes, property taxes, sales taxes,
excise taxes……..
BRACKETS AND RATES: TAX YEAR 2015
Marginal Tax Rate
39.6%
Taxable Income
Single Individuals
$ 413,200 and above
35%
$ 411,500
33%
$ 189,300
28%
$ 90,750
25%
$ 37,450
15%
$ 9,225
10%
Sponsored by the Center for Women & Financial Independence