3 Things New Professionals Need to Know About Taxes - The Broke Professional

3 Things New Professionals Need to Know About Taxes

My note:  The following is a gracious guest post from Kathryn, who has an excellent blog called Making Your Money Matter.  If you want a complete financial lesson on any and every financial topic from an actual financial professional, head on over to her website.  Honestly, this is the type of information that I’ve seen only available in paid courses, but you can get everything on her site free and clear.

Without further ado, here is a fantastic post by Kathryn talking about some essential tax tips for professionals.

Kathryn Hanna is a CPA and specialized in business and personal taxes when she worked in public accounting.  She currently stays home with her 3 children and blogs at www.makingyourmoneymatter.com to help people improve their understanding of personal finance and thereby improve their lives.  She loves all things money and especially spreadsheets.

If the only sure things in life are death and taxes, I’m sure we can all concur that it’s more fun to talk about taxes than death.  The basic formula for taxes is really quite simple, it’s just the fact that there are so many exceptions and rules that make it incredibly complicated.  Fortunately, you don’t have to know all the rules, just the ones that you need for your own personal taxes!

There are 3 things that I believe will be most beneficial for every new (or even not so new!) professional to know related to taxes.  These are things that will help you reduce taxes and build as much wealth as possible.

1. TAXES MAY BE YOUR SINGLE LARGEST EXPENSE

Once you’ve gotten used to the huge chunk of money being taken out of your paycheck for taxes, you might just ignore taxes altogether (at least until April each year!).  However, FICA, federal and state taxes alone will likely be upwards of 15-20% of your pay.  I calculated my total taxes as a percentage of my income for 2016 and found that over 25% of my income goes toward various types of taxes.  This is my largest expense, exceeding my total housing expenses including utilities!  Likely, taxes just might be your largest expense as well!

While I acknowledge the importance of tax funds to keep our country running, I’m all about minimizing my taxes to not have to pay more than my legal share.  By learning more about how taxes impact various decisions, you can minimize your taxes and keep more of your money in your pocket.

The first step is to get a really good understanding of your current tax situation.  Go through your most recent tax return and make sure you understand, line by line, each and every income, deduction, credit, and tax calculation.  If you have any new financial situation come up, research and make sure you understand the tax consequences.

2.  ALL INCOME IS NOT CREATED EQUAL FOR TAX PURPOSES

As a new grad, you were probably super excited about having any sort of income.  A paycheck large enough to cover eating out instead of sitting at home with Ramen noodles or a tuna sandwich is life-changing.  Earning income is great!

However, that salary you are getting is the nearly the most expensive type of income there is.  First, you’ll be paying Social Security and Medicare taxes on it at a rate of 7.65%.  Then, you’ll need to pay federal income taxes on your salary likely in the range of at least 10-15% if you’re a single person just starting out.  Also, your state will want their cut of taxes, which will add another few percent (the tax rate is 4.25% in my home state of Michigan).  That’s a lot of your hard-earned money going to taxes.

The only income that is even more expensive to you than employment income is self-employment income due to having to pay twice the Social Security and Medicare taxes.  However, being self-employed can increase your income at much higher levels than working for someone else, so I’m definitely not discouraging it!

Most types of income are taxed at ordinary tax rates for federal and state purposes but are not subject to FICA taxes.  Examples of these types of income include:

  • interest income
  • short-term capital gains on investment assets held for less than a year
  • rental property income
  • retirement distributions (someday!)

There are also types of income that are not subject to FICA taxes and are also taxed at lower tax rates.  These types of income are actually taxed at a 0% rate for those in the 10-15% tax bracket (single filers up to $37,950 adjusted gross income for 2017).  Then they are taxed at only 15% for most people.  These types of income include:

  • qualified dividends
  • long-term capital gains on investment assets held for at least a year

There are even income streams that are not taxable at all for federal income tax purposes:

  • interest from municipal bonds (although this may be taxable in some states)
  • gifts, bequests, and inheritances

The moral of the story here is to increase your other income streams in addition to increasing your salary.  Taxes make a significant difference in the amount of your income that you actually keep, so increasing your portfolio income will help you get ahead in the long run.  In addition, saving money in retirement accounts will help you to defer your tax on that income for 30+ years or more.  It will make a huge difference in helping those funds grow more quickly for your future retirement.

3.  HOW TO CALCULATE YOUR MARGINAL TAX RATE

Another vital piece of knowledge is understanding your marginal tax rate.  Your marginal tax rate is the percentage of tax you will pay on your next dollar of earned income.  This is not to be confused with your effective tax rate, which is determined by dividing your total federal tax liability by your total income.

The main reason that there is often a large difference in the marginal versus effective tax rate is because the U.S. has a progressive tax system.  A progressive tax system is where the tax rates increase with higher income levels.  Those with high income are still taxed on the lower rates for the lower portion of their income.  This is shown in the tax rate brackets shown in the example below.

In addition, the difference in effective and marginal rates may also be due to a substantial amount of non-taxable income items or tax deductions and credits that decrease income.

An explanation of marginal and effective tax rates is best explained through a simple example.  Assume the following information for 2016:

  • Your annual salary is $55,000
  • You contribute $5,000 to a traditional 401(k) account
  • You have paid $1,000 in student loan interest
  • The standard deduction is $6,300
  • The personal exemption amount is $4,050

This quick tax summary shows your tax liability of $5,435 for 2016:

The effective rate you are paying on your taxes is only 9.9%, which is calculated as $5,435 in total tax divided by $55,000 gross income.

However, your marginal tax rate is 25%.  Your next dollar of income will actually be taxed at a 25% rate, assuming it doesn’t give rise to additional deductions (for example, if you contribute this “extra” money to retirement accounts, it will not be taxed currently).  The marginal tax rate is determined by looking at the highest tax bracket, as determined by your taxable income.

Looking at the tax rate table below, you can see that with a taxable income of $38,650, this would put you in the $37,650-$91,150 bracket, which is taxed at a rate of 25%.

Looking at the tax table, you can also see that you can earn an additional $52,500 in income before increasing your marginal tax rate to 28% ($91,150 less $38,650).

Understanding your marginal tax rate will give you a realistic view of how much that raise or bonus is actually going to be on a cash basis for you.  It also will hopefully encourage you to contribute more to retirement accounts as your marginal tax rate goes up and those tax deductions become worth even more.

FINAL THOUGHTS

Understanding income taxes is key to building your wealth through the years.  Because of the progressive tax structure in the Unites States, it is even more important to understand your taxes as your income grows throughout the years and the value of your tax deductions increases.

Start now by looking at your current tax situation, making a plan to increase your passive income streams and determining your marginal tax rate.  Future you will thank you!

This information is meant for educational purposes and does not represent individual tax advice.  If you have questions about your personal tax situation, it is highly recommended to meet with a tax advisor or attorney.

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Comments

  1. Great post Kathryn! Quick question, are there better tax advatantages with having an LLC as opposed to filing as “self employed”? Or is having an LLC just for the legal benefits?

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