Income Tax Basics – Part 2: How to Control Your Income Tax As a Single Filer

“Taxes! Grrr! I pay all this money to the IRS and I don’t even make that much. Plus, it’s such a mystery! I just hope to get a big refund this year.”

-Max

We met Max in Part 1 of the Tax Series. He’s a single filer whose only income was the $50,000 of wages earned at his job. Max had no deductions, no dependents, and no clue how to control his income tax.

In Part 2, we’re going to learn that Max has a lot of control on how much he pays in income tax. He can direct his tax and income like an air traffic controller directs takeoffs and landings. But there’s a catch! He’ll have to reduce his take-home income.

By taking control of his taxes, Max can find the right balance between take-home income and how much he pays in income tax. In the end, there will be smiles and high-fives all around, and definitely no mid-air accidents.

Max’s Salary Is… Gross

The thing about Max’s $50,000 gross salary is that he’s not taking all of it home. Max will have various pre-tax deductions diverted from each paycheck. Plus, he’ll have income tax withholding removed as well. This all reduces his take-home income as his paychecks shrink.

Pre-Tax Deductions

Let’s look at each of Max’s pre-tax deductions over the entire year. There’s Medicare and Social Security (known as FICA), medical insurance, and dental insurance.

Max’s Gross Salary$50,000
Medicare and Social Security (7.65%)-$3,825
Medical Insurance-$2,585
Dental Insurance-$290
Take-Home Income$43,300 ($50,000-$6,700)

After these pre-tax deductions, Max’s take-home income is $43,300. This is the amount that’s reported on his W-2.

Total Tax Calculation

Now let’s apply the standard deduction and the tax brackets that we learned about in Part 1. We’ll use that information to determine Max’s taxable income. Then we’ll calculate what he’ll pay in federal income tax.

Take Home (W-2) Income$43,300
Standard Deduction-$12,000
Taxable Income$31,300
Tax in the 10% Bracket$952.50
Tax in the 12% Bracket$2,613
Total Tax$3,565.50

The standard deduction brings Max’s taxable income down to $31,300, which results in $3,565.50 in total tax. That’s $804 less than the $4,369.50 Max paid in Part 1. This is no mystery: Less take-home income means less tax.

Tax Withholding

Next, let’s consider Max’s income tax withholding. His employer siphons this money from his paychecks to pay the IRS. His tax payments are portioned and paid throughout the year instead of paying all at once.

In a perfect world, the amount of Max’s withholding would exactly match his total tax. The IRS even has a Withholding Calculator to help with this. And Max can adjust his tax withholding any time on his Form W-4.

Max can adjust his withholding on Form W-4

However, despite best efforts, an exact match doesn’t usually happen. This results in taxpayers either owing money to the IRS or getting a refund.

Max’s withholding is set to be $4,300, divided up throughout the year as $165 per paycheck. But his actual total tax is $3,565.50. That’s a $734.50 difference, which he’ll receive as a refund when he files his taxes.

So far, so good. But Max can reduce his total tax even more with tax-advantaged accounts and by qualifying for a tax credit or two.

About Those Tax Refunds

Many Americans don’t know or don’t care how much they pay in income taxes. Instead, they’re laser-focused on how big their refund might be when they file their taxes.

Some even withhold more than necessary from their paychecks on purpose to ensure a big payout in the form of a refund. But the “big payout” is their own money that they’ve loaned to the government.

This behavior doesn’t make logical sense. But—like mortgage principal payments—it acts as forced savings for non-savers. The problem is, this “savings account” pays 0% interest. And you can only access your money once per year when the IRS sends your refund. Ouch! Don’t make the IRS your savings account.

Less Income Means Less Tax

The main tool Max has reduce his total tax is to reduce his taxable income. After all, it’s right there in the name: income tax.

We already saw the effect of reducing income with Max’s pre-tax deductions. Those shrunken paychecks resulted in lower income and a lower total income tax.

Max can shrink his income even further—no pay cut required—by using tax-advantaged accounts. The money he diverts into these accounts avoids taxation for the current tax year. And, in some cases, the money is never taxed!

Tax-Advantaged Accounts

Max has access to four types of tax-advantaged accounts, described below. Each account type has its own contribution limit, which can change from year to year.

401(k): Offered by an employer. Contributions are pre-tax. The money goes in tax-free and is only taxed when it’s taken out. Contribution limit in 2018: $18,500

Individual Retirement Arrangement (IRA): Set up by, and belongs to, individuals. Two flavors: Traditional IRAs are pre-tax. The money goes in tax-free and is only taxed when it’s taken out. Roth IRAs are post-tax. The money gets taxed before it goes in and is never taxed again. Contribution limit in 2018: $5,500

Health Savings Account (HSA): Pre-tax savings account for healthcare expenses. Funds can be saved or invested. Contributions are tax-free. And distributions are tax-free too, if used for qualified medical expenses. Contribution limit in 2018: $3,450

Flexible Spending Account (FSA): Pre-tax savings account for healthcare expenses. The money goes in pre-tax (tax-free), but there’s no saving or investing component. Used to pay for known medical expenses with tax-free money. Often must use the funds within a year or two, or else the money goes away. Contribution limit in 2018: $2,650

If we add up all those contribution limits, we find that Max has $30,100 of tax-advantaged space! He can use this space to lower his taxable income, and thus lower his total tax. Or he could choose not to. It’s all under his control!

An Extreme Approach 

A para-surfer
This is the extreme approach to lowering Max’s income tax.

At Max’s income level, he might struggle to take full advantage of all these accounts. After all, he’s only taking home $43,300 after his existing pre-tax deductions. 

Regardless, let’s go crazy* and test the limits of what’s possible. Then we’ll look at a more conservative approach.

First, Max will “max out” (contribute the maximum allowed) his 401k, Traditional IRA, and HSA. He’ll also contribute $650 into an FSA for some upcoming medical expenses.

Max’s Income After
Pre-Tax Deductions
$43,300
401k-$18,500
Traditional IRA-$5,500
HSA-$3,540
FSA-$650
Total Income After Using
Tax-Advantaged Accounts
$15,200
Standard Deduction-$12,000
Taxable Income$3,200
Tax in the 10% Bracket$320
Tax in the 12% Bracket$0
Total Tax$320

The tax-advantaged accounts bring Max’s total income down to $15,200. Then the standard deduction results in a tiny $3,200 of taxable income with a total tax of $320. Very interesting… but we’re not done yet. Let’s see if Max qualifies for any tax credits.

Tax Credits

Tax credits are different than deductions. In fact, they’re better! Tax credits reduce the total tax that you owe, dollar for dollar. Deductions reduce the income that you’re taxed on.

Some credits are also refundable, which means they reduce your total tax and refund what’s leftover. Refundable tax credits are the holy grail of credits!

Most tax credits have requirements such as a maximum Adjusted Gross Income (AGI). AGI is “a measure of income calculated from your gross income and used to determine how much of your income is taxable,” according to Investopedia. AGI falls somewhere between total income and taxable income.

A few common tax credits are the Child Tax Credit, the Saver’s Credit, and the Earned Income Tax Credit (EITC).

Max’s Tax Credits

Max doesn’t have a child, so the Child Tax Credit is out of the question. But he might qualify for the Saver’s Credit or the EITC.

Because Max’s AGI is under $19,000, and he contributed enough to retirement accounts, he’s eligible for $2,000 of Saver’s Credit. But this is a non-refundable credit. That means it’ll reduce his $320 tax bill down to zero, but he won’t get refunded the remaining $1,680.

The EITC is meant to help low to moderate income families. Max could be eligible, even though he doesn’t have children. But he needs a low enough total income (Under $15,270 in 2018). Max’s total income is $15,200 so he barely squeaks through, and picks up a refundable $3 credit.

“Three dollars?!?! What good does that do?”

A $3 credit is kind of silly, but there it is anyway. Enjoy!

Now let’s factor in the Saver’s Credit and the EITC into Max’s numbers.

Total Income After Using
Tax-Advantaged Accounts
$15,200
Standard Deduction-$12,000
Taxable Income$3,200
Tax in the 10% Bracket$320
Tax in the 12% Bracket$0
Total Tax Before Credits$320
Saver’s Credit-$320
EITC-$3
Total Tax After Credits-$3

Max went from a total tax of $3565.60 all the way down to -$3. That’s right, the government is now going to pay him a few bucks!

Mayday! Mayday!

Negative three dollars in income tax? That’s sure is fun! There’s only one problem: Max’s take-home pay is now JACK SQUAT ($15,200 plus $3 in a refundable tax credit).

Max’s take-home pay is not going to amount to JACK SQUAT!

Maybe Max can embrace hardcore frugality, read Upwardly Frugal, and somehow cut his expenses down to the bone. Otherwise, he could back off a bit on the tax-advantaged accounts. He could find his sweet spot between take-home pay and income tax with a more conservative approach.

A More Conservative Approach

A man in a suit
This is the more conservative approach to lowering Max’s income tax.

Max knows his actual cost of living is around $32,000 per year. And he knows he wants to contribute to his Roth IRA instead of a Traditional IRA.

This is because he’s in a low marginal tax bracket of 12%. It makes sense for him contribute to the Roth IRA with post-tax money. Then he’ll enjoy the tax-free distributions later in life when his tax rate is likely to be higher.

With those restraints in place, here’s an example of how Max can make it all happen. He’ll maintain his required take-home pay, max out his Roth IRA, and use the pre-tax accounts to reduce his income tax.

Max’s Income After
Pre-Tax Deductions
$43,300
401k-$2,700
HSA-$3,450
FSA-$650
Total Income After Using
Tax-Advantaged Accounts
$37,500
Standard Deduction-$12,00
Taxable Income$25,500
Tax in the 10% Bracket$952.50
Tax in the 12% Bracket$1,917
Total Tax$2,869.50

In this conservative approach, Max still takes advantage of his pre-tax accounts. But he contributes a lower amount. This allows him to also max out his Roth IRA and leaves him with the $32,000 of take-home pay that he needs. His total tax in this scenario is $2,869.50.

Conclusion

The lesson is this: Max’s income tax is not a mystery that’s only solvable by certified public accountants and $50 tax preparation software.

Max’s expenses, income deductions, and tax credits are very knowable. So he can plan ahead and at least get a good estimate. Max can run his numbers toward the beginning of the year. Then he can watch his tax situation throughout the year, and make adjustments as needed. Like an air traffic controller, he’s in control. And he shouldn’t have any big surprises when he files his taxes.

Max can stop relying on his tax refund as a forced savings account. He’ll use tax-advantaged accounts instead. That’s how Max can control his income tax as a single filer. It’s all part of an exciting activity that he’s never done before. It’s called tax planning.


Do have control of your income tax? Your answer is cleared for landing in the comments.

*This is considered “crazy” because of Max’s moderate income. If Max increased his income or married into a two-income household, it would probably make sense to max out every tax-advantaged account under the sun.

Disclaimer: The author is not a tax professional and is not providing tax advice. Do your own research and talk to a professional before making any tax moves.

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