How Do Taxes Work?

Nobody likes paying taxes. Paying taxes to the government is like sharing your lunch with someone selfish; they’ll take your sandwich and wonder why you haven’t given them your cookies too.

For something we all deal with, understanding how income taxes work can be confusing without an explanation.

Well, here’s that explanation!

What taxes do I pay on my income?

Your income is subject to three major kinds of income taxes: federal income taxes, state income taxes, and Social Security taxes.

All income-earners in the US are subject to federal income taxes and Social Security taxes.

Federal income taxes are those we pay to the U.S. government to cover things like infrastructure, public transportation, the military (thank me for my service, and thank you for my income), and other fun ways the government spends money. Federal income taxes generally increase every year with inflation.

Social Security taxes go toward… well… Social Security. They are set at a fixed rate of 6.2% of your gross income for employees and 6.2% for employers, at a total rate of 12.4%. Self-employed individuals (acting as the employee and the employer) have to pay the full 12.4% themselves. Social Security tax rates have not increased since 1990. Why? Not sure, but the future of Social Security is looking interesting as a result (more on that in two weeks!).

Most states also charge you a state income tax on top of federal income taxes. Depending on the state you live in, they could have a progressive tax rate (meaning the rates get higher as your income goes up), flat tax rate, or no taxes at all. Check out this link to see how your home state is taxing you, if at all.

Part of maximizing your income is understanding the tax implications of your current living situation. Florida has no state income taxes, while California's state income taxes cap at 13.3%. However, states with no income tax can tax you more heavily in other ways, such as sales or property taxes.

I’m not suggesting you should uproot your life in California to move to Florida. But it is important to consider the cost of your current living situation, and evaluate your feelings on alligators before deciding to make a cross-country move.

How do federal income taxes work?

A common misconception about federal income taxes is that the US government taxes all your income at your highest marginal tax bracket. This isn’t the case.

The US has a progressive tax system, meaning your money isn't all taxed at the highest bracket you are in. Different portions of your income are taxed at different rates. The table below lists the 2023 federal income tax rates for single tax-filers and married couples that file taxes together.

Because federal income taxes are progressive, all of your income isn’t penalized with increased taxes as you move from one tax bracket to the next. Just the chunk of money within a given tax rate. If your income bumps you into the next tax bracket by $1, only that $1 will be taxed at the higher rate.

Here’s an example of how this plays out in real life. Let’s say you’re a single individual with an annual income of $40,000. Your first $11,000 will be taxed at the 10% rate and the remaining $29,000 ($40,000 minus the $11,000 that’s being taxed at 10%) is taxed at 12% rate. So your effective tax rate, or the average percentage of your income that you're taxed on, is 11.5%. This doesn’t account for the standard deduction that’ll reduce your taxable income when filing taxes (check out this newsletter if you need a refresher on how the standard deduction works).

This is why it will always benefit you to earn more money.

If I’m married, is it better to file taxes jointly or separately?

99.9% of the time, it’s better to file taxes jointly. There are a number of tax benefits available for joint filers that separate filers won’t be eligible for like deducting Traditional IRA contributions or contributing to a Roth IRA.

How can I decrease the amount of income taxes I owe?

The easiest way is tax evasion. The best (and most legal) way is to invest your money within tax-advantaged retirement accounts like an IRA or 401(k). You can also invest your money into real estate, hire a CPA, and take advantage of all the tax bennies associated with real estate investing. Our complex tax system just means those who can afford a CPA use legal methods to lower their tax bill.

Why doesn’t the government tell me exactly how much I owe in taxes?

More thoughtful answer: It’s impossible for the government to predict exactly how much money you’ll owe based on your total income, the deductions you’ll claim, and many other factors, so the taxes you pay are based on a best guess of what you’ll owe. Then, come tax season, you either get refunded or you pay more money.

Less thoughtful answer: Because they suck. Plus TurboTax and the IRS have to get theirs somehow. TurboTax spends a lot of money making sure you have to give them money to file your taxes and the government doesn’t make a free file system. Sadly, this isn’t a conspiracy. Read more about it here.

Call to Action

Take a look at your 2022 W2 to see how much money you paid in taxes. Evaluate how you can reduce your taxes by investing in a Traditional IRA or employer-sponsored retirement plan.

What We’re Reading/Listening To:

Audiobook: Good to Great by Jim Collins. Is it any good? Not sure, I just started it yesterday. But I hear that it’s solid and I’m highly interested in his take on what makes great companies great.

Debrief on Deck

Next week, Wilson is going to break down the growth versus dividend investing debate. Wilson has a strong opinion on the topic, which is probably shocking to hear…

As always, please reach out to us with any questions or comments you have. You can reply directly to this email or find us on social media (X (formerly Twitter) and Instagram).

Until then, stay the course.

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