January 2023 newsletter
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From now on, the monthly newsletter from Milky Way Retirement will focus on the questions my clients asked me during the last year. I answered them all via video call or chat, but now I'll put them in writing so that others can benefit from them also.
This January will start with questions about Individual Income tax. Although we get tax return forms every year, it may be hard for some to understand the difference among tax terms like marginal tax rates, effective tax rates, or tax brackets. I am not ambitious to be a CPA, but I hope this newsletter can give you a basic view of your tax landscape.
The Federal income tax has seven levels of tax rates, which are known as marginal tax rates: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. It's obvious that the more income you have, the higher tax rate is applied. It also depends on your marriage status: single or married.
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| Source |
So, how is your income tax really calculated?
If you are single, and your income is $80,000 a year, your marginal tax rate is 22%.
Tax brackets are the income cutoff points before your income causes you to move into a higher or lower tax bracket. Your income is $80,000, lower than the bracket of $89,075 and higher than the bracket of $41,776.
However, your tax is not simply calculated by dividing your income by 22%. Your income will be broken into portions based on the brackets. In another word, your income will fall into multiple tax brackets.
Looking at the table above, your $80,000 income falls into 3 tax brackets
- The first $10,275 will be taxed at 10%,
- 12% for the second bracket from $10,276 to $41,775, which means: 12% x (41,775-10,276)
- 22% for the third bracket from $41,776 to $80,000, which means 22% x(80,000-41,776).
So your tax amount is the sum of $1,027.5 (10%), $3,779.88 (12%), and $8,409 (22%), which is $13,216.
With the same $80,000 income but if you are married and you file the tax jointly, your marginal tax rate is 12%, and your tax amount is the sum of $2,055 (10%) and $7,133 (12%), which is $9,188.88.
You can look at my simple calculation on Google Sheets in the picture.
So what is the effective tax rate?
You are single with an $80,000 income, your tax amount is $13,216.66. Your marginal tax rate is 22%, but your effective tax rate is 16.5%, which is calculated by dividing $13,216.66 by $80,000.
If you are married and you earn $80,000 annually, your effective tax rate is 11.49%.
So those are the simplest tax calculation without DEDUCTIONS or Tax Credits. You should refer to the official website of the IRS to learn more about deductions.
Tax deductions are subtracted from your gross income, therefore the amount of tax you owe is lower.
You can choose the standard or itemized deductions.
Standard Deduction is the amount of money set annually by the IRS and is also different based on your marriage status.
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| Source: Investopedia |
We will go back to the $80,000.
So, in reality, your taxable income is not $80,000.
If you are single, you can deduct $12,950 from $80,000. So you now pay tax on $67,050 only. And the tax amount you owe now is $10,367 instead of $13,126 when the standard deduction was not calculated as above. Your effective tax rate is now 15.46%.
Similarly, if you are married and file the tax form jointly, you can apply the standard deduction amount of $25,900. Therefore your taxable income decreases to $54,100 and you owe $6,080.88 in federal income tax. Your effective tax rate is now 11.24%.
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| My simple tax calculator via Google Sheets. |
You can use Itemized Deductions under some conditions and you are sure that you have more to deduct than the Standard Deductions. Perhaps you paid more on medical bills, and mortgage interest or you donated a big sum of money to qualified charities. You should consult with your tax preparer or CPA before making decisions on using the Standard or Itemized Deductions
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| Source: WallStreetMojo |
Tax Credits can also help you reduce the amount of tax you owed. For example, if you have children, you are qualified for Child Tax Credits.
You can see that with the same income amount, the married joint filer pays less tax than the single filer. The Standard Deduction is higher for married couples filing jointly.
It seems that marriage is encouraged by the U.S. government. However, Dorothy A. Brown, Professor of Law at Emory University, in her book "The Whiteness of Wealth: How the Tax System Impoverishes Black American--and How We Can Fix It", observed that one-income married couples may get bonuses while 2-income couples may get tax penalties for filing jointly.
You can read more about marriage bonuses and marriage penalties to find which one is more advantageous for you, married filing jointly or separately.
So, looking back:
What was the tax amount you owned in 2021?
Did you get any Tax Deductions or Tax Credits?
What was your effective tax rate?
Do you think that you paid a fair amount of tax?
What will roughly be your tax amount this year?
A few weeks ago, one of my friends shared a link about President Trump's tax return.
According to the article, President Trump and his wife paid $750 or less in federal income tax in 2016 and 2017.
The couple paid zero taxes in 2020 and claimed a $5.5-million refund.
They paid $641,931 in 2015 and $133,445 in 2019.
In 2018, their gross income was $24,395,093, and they paid $999,446. In his presidency period, this was the year President paid the highest amount. However, his effective tax rate was only 4%.
By contrast, the average taxpayer in 2018 paid about 13% of their income.
The article reminded me of another article in 2021 revealing the tax amount paid by the wealthiest men like Warren Buffet, Jeff Bezos, Elon Musk, and others.
Jeff Bezos paid $0 federal tax income in 2007. Elon Musk also paid the same amount in 2018. Their highest effective tax rate was below 4%.
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| Source: ProPublica |
How do you feel reading these articles?
My friend asked these questions:
- Do you feel disturbed that the richest men in America can LEGALLY avoid paying a lot of taxes?
or
- Are you impressed that the richest men in America can LEGALLY avoid paying a lot of taxes using the rules of the tax code?
So, it is your choice to be annoyed that the ultrawealthy could legally avoid taxes or to learn their strategies that can also legally reduce your tax.
Thanks for reading this first newsletter in 2023.
Milky Way Retirement
P/S: The February newsletter will answer a question which my client asked me last year: "Should I buy T-bond?"
If you know any friends interested in the answer, please ask them to subscribe here, and they will receive the answer in their email inbox.
You can also send me your questions via this email address: milkywayretirement@gmail.com
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