Taxes: A Guide for Recent Workforce Entrants
Congratulations, you’ve just won and accepted your first “real job” offer. Whether you’re working in a retail store, a skilled trade, or a cubicle, you share one thing in common with your fellow workers. Can you guess what that is?
You’re going to have to pay taxes.
There’s tremendous confusion about how the US tax system works. You’ve probably heard a lot of half-truths and nonsense from people who don’t understand the concepts of progressive taxation, deductions, and credits.
Understanding Progressive Taxation
A lot of people get confused about this one. Some people think that by making more money, you’ll pay more taxes than you would have at your lower, current pay level.
That’s just not true.
Progressive taxation is easy to understand — up to a certain limit, your income is taxed at a certain rate. The higher you go, the more the limit increases until it reaches a cap (39.6% for earnings of $415,050 and beyond for single filers this year).
Here’s a table of tax brackets from the Tax Foundation:
Let’s do an example. Say that you get a job as an entry-level accountant making $48,000 per year. You’re a single filer. Based on this table, how much would you pay in tax?
Here’s how you figure it out:
- For your first $9,275, you’ll owe 10%: $927.50.
- From $9,275 to $37,650, you’ll owe 15%: $4,256.25.
- From $37,650 to $48,000, you’ll owe 25%: $2,587.50.
Your total tax bill is $927.50 + $4,256.25 + $2,587.50 = $7,771.25.
That means you actually took home $40,228.75 for the year. Ouch! And we haven’t even looked at FICA, state taxes, and municipal taxes (if you live in New York City, for instance, you’re going to pay an extra 3%).
The point here is that you don’t pay 25% on your entire income. You pay specific rates for specific ranges — these are called tax brackets. And that’s how a progressive income tax works.
Deductions and Exemptions to the Rescue
The good news is that the IRS offers both a standard deduction and a personal exemption for single filers as in the previous example. In 2016, the standard deduction is $6,300 and the personal exemption is $4,050.
You don’t actually pay taxes on all $48,000 of your income. Instead, you pay taxes on what is known as your taxable income — your total income less any deductions or exemptions.
In this case, your taxable income would be $48,000-$6,300-$4,050 = $37,650. Nice!
How much do you have to pay, now? Look at the previous example and notice that all we have to do is lop off the third calculation. The actual amount of taxes you owe would be $5,183.75, and your new take-home pay is actually $42,816.25.
In reality, your situation may be more complicated. For instance, you can choose to itemize deductions instead of taking the standard deduction. However, if you go this route, then you’re going to have to make sure you’re listing valid expenses. The rules governing itemized deductions are very strict, and violating them can trigger an IRS audit.
Tax Credits: No, They’re Not Deductions
You may have also heard the term “tax credit.” A tax credit also decreases your tax bill, but it does so in a different way than tax deductions and exemptions.
Deductions decrease your taxable income.
Credits decrease your taxes due.
See the difference? Credits reduce your tax bill directly.
Let’s look at the previous example again. Remember how you owed $5,183.75 after applying the standard deduction and personal exemption to your gross (before tax) income? Pretend that you also decided to buy a solar PV array for your home this year, too.
After carefully researching the available tax credits for this year (or using a program like TurboTax), you discover that there is a tax credit for individuals who install clean energy systems — like your PV array!
It’s called the Residential Renewable Energy Tax Credit. Here’s what the government has to say about it:
A taxpayer may claim a credit of 30% of qualified expenditures for a system that serves a dwelling unit located in the United States that is owned and used as a residence by the taxpayer.
So, if you paid $10,000 for your new solar panels, then you could claim a $3,000 tax credit for the year!
Your new tax bill is $5,183.75-$3,000 = $2,183.75. That brings your net (after tax) income to $45,816.25. Awesome.
But Wait, There’s More!
That’s a lot information at once, and there’s a lot more ground to cover. We haven’t even scratched the surface of topics like FICA and state taxes, and how you can shelter more of your income from taxes through retirement programs like 401(k)s and IRAs.
We’ll save those retirement account topics for a later date. In the meantime, here’s what you need to know about FICA and state taxes — as well as personal income taxes that certain cities (NYC, for example) also levy.
FICA: Federal Insurance Contributions Act
By enacting FICA, the government created a payroll tax to fund Social Security and Medicare. On your pay stub or W-2, the form your employer gives you at the end of the tax year, you’ll find that FICA taxes have been withheld from your paycheck. You can find the tax rates for Social Security and Medicare here.
You’ll notice that the rates are different depending on your employment status. Self-employed individuals will not have an employer to partially cover this tax, so they will pay a higher rate.
Don’t Forget State (and City) Taxes
The state you reside within will also have its own set of taxes. Most states have an income tax, and each state government will have defined its own tax brackets. Unless, however, you’re in a state with a flat tax — such as Pennsylvania.
The following states do not have an income tax:
- South Dakota
- New Hampshire*
These states do not tax regular income, but they do tax interest and dividends.
Remember, just because you’re paying fewer taxes doesn’t necessarily mean your total tax burden will be lower in these states. They may attempt to make up for the shortfall in income tax revenue with sales, fuel, and property taxes, for instance.
Finally, if you live in a city like New York City, you’ll also have to pay income taxes to the city government. Make sure your employer withholds this tax, or else you’ll be in for a surprise at the end of the tax year.
Putting It All Together
After calculating taxes withheld from your paychecks, your deductions, exemptions, and credits, you’ll be able to determine if the Federal and state governments owe you a refund — or if you owe them more money.
If, when you file your tax return, you find that you paid more than your fair share, you’ll be eligible for a refund from the government. People often think that a refund is “free money” when in actuality it is the government cutting you a check because you paid too much tax! Well, that’s not always true — low income individuals may also receive a refund even if they didn’t pay any taxes.
Here are a few things you’ll want to keep in mind as an employee:
- Regularly check your pay stubs to ensure that everything looks normal — if you notice that your employer is withholding too much or not enough, you’ll want to address the problem ASAP to avoid any surprises at the end of the tax year.
- Keep track of your possible tax credits for the year — you’ll want to take advantage of these to receive more money back from the government.
- Contribute to your company’s 401(k) or 403(b) if available. These retirement programs allow you to reduce your taxable income for the year by the amount you contribute to them.