Tax Planning 101

In this video, Matt and Ben break down how tax brackets work, providing a detailed analysis for a hypothetical household with a combined income of $500,000. They explain the different types of taxes that impact one’s pay, including federal taxes, state taxes, Social Security tax, Medicare tax, and local taxes. They show how these taxes are calculated and the impact on the household’s net take-home pay.

The video emphasizes the importance of understanding tax brackets, especially for higher-income earners, and suggests that individuals should audit their pay stubs when receiving bonuses or 1099 income to ensure correct tax withholding and avoid surprises at the end of the year.

Additionally, they mention that other benefit cost-sharing, such as health insurance and life insurance, can further reduce take-home pay, and individuals should consider these factors when budgeting their finances.

Video Transcript

In today’s video, we are going to break down how tax brackets work. And for many of you are wondering, where does all my money go before I actually see the net amount deposited from my paycheck? Give us a high level overview.

What are the different kind of taxes that hit someone’s pay? And then let’s get into detail. Yeah, so a couple of different things that we want to be aware of. First and foremost, there’s your federal taxes, and those are based on a progressive system.

And we’ll walk through a more detailed analysis shortly. But also, depending on the state that you live in, there’s going to be a state or a local tax. This could either be flat, this could be graded.

There’s also Social Security tax that’s capped right now in 2022. At the first $147,000 of income that you make, there’s going to be a 6.2% Social Security tax. Also, there is a Medicare tax that you’re going to have to pay that’s 1.45%, and that is uncapped.

So no income limit on that Medicare tax. Ben, thanks for the high level overview. Let’s go into a detailed analysis. Yeah, so we’re going to assume that two spouses combined are making $500,000. So if you look at this sheet here under the cash flow tab, we have spouse one and spouse two both making $250,000.

So that would be considered our gross income. And so what’s considered gross income? It’s any wages, salaries, tips, any dividends or interest that are reported on Schedule B. And if you were to ever do like a Roth conversion from a traditional IRA to a Roth IRA, that amount of the conversion would be considered taxable income as well.

So everything is thrown in that pot of gross income. The only things that aren’t included, if you receive any gifts or if you receive any in inheritance, those are two things that are not included in your gross income.

Next, we need to get from gross income to our adjusted gross income a couple of ways we can do that. Number one, we could contribute to a health savings account. We could contribute to a traditional 401 or a Sep IRA.

Or a profit sharing plan. Or we can contribute to a traditional IRA. Those are all what are called above the line deductions, and those take us from gross income to adjusted gross. So for simplicity’s sake, we’re going to keep our adjusted gross income at 500,000.

Next, we can either take the greater of our standard deduction or the sum of our itemized deductions. In 2022, if you’re married filing jointly, your standard deduction is 25,900. If the sum of your itemized deductions is greater than that number, then we would take the itemized deductions.

So what are your itemized deductions? Those are your state and local taxes, personal property taxes and real estate taxes. Those are all capped at $10,000. There’s any charitable giving that you do and also home mortgage interest up to $750,000.

So the combination of all those things, if that’s greater than 25,900, we would choose to itemize. But again, for simplicity’s sake, for example, we’re going to use the standard deduction and find our total taxable income of $474,100.

So moving towards the 2022 tax estimate, to get an estimate for our federal tax liability, $474,100 puts us in the 35% tax bracket. But it’s important to remember that the United States tax system is progressive.

So you’re not paying a 35% flat tax from a federal standpoint. You need to move through the brackets. So there’s a 10% rate, a 12% rate, a 22% rate. On down the line, we’re going to pay tax at the 10% rate, the 12% rate, the 22% rate, really only the amount that is between 474,000 and that 431,000.

That’s only the amount that’s going to be taxed at that 35% rate. Go through the table and do the math. And that estimates our federal tax to be about 113,000. So moving down to the bottom left corner of our spreadsheet again, we have our taxable income, 474,000.

We just estimated our. Our federal tax of about 113. We’re assuming that we’re in Pennsylvania here. Pennsylvania has a 3.7% state tax. There are certain states that have higher state taxes. There are certain states that have no state tax.

But we just wanted to use Pennsylvania as a baseline Social Security tax. That’s again capped at $147,000 of income for each spouse, and that’s a 6.2% tax. So again, not on that full $474,000 number.

It’s only capped at 147. And that Social Security tax of 18,000 is for both spouses combined. So the Medicare tax of 1.45%, that’s uncapped. So that’s going to be hit at our taxable income of 474,000.

So for both spouses, our Medicare tax is again 6800. Local tax, again, we’re going to assume in Pennsylvania, we’re going to assume 1.5%. That could be higher. That could be lower. So our local tax combined is about 7000.

That leaves our net take home we started our taxable income at 474. Our net take home after federal, state and other taxes is about 313,000. For this case scenario, we’re going to assume that both spouses max out their Roth 401K deferrals at 20,500 for each spouse for each year, and that’ll leave our net monthly income of about $22,700.

Ben, thanks for providing such a detailed breakdown of the taxes. If you are a household with half a million dollars of income has been meticulously broke out during this video, bottom line is you can expect a 34% deduction for all these taxes out of your paychecks.

If you’re trying to figure out high level, what are we going to take home on a monthly basis at 34%, that, however, does not include. Other benefit cost sharing such as health insurance, disability insurance, life insurance, et cetera.

And some of our clients have things like parking taking out of their paycheck. So in general, it’s smart to add an additional 3% for these other deductions. So if you’re a half million dollar household, we would expect in Pennsylvania, assuming the assumptions that we’ve made, that about 37% of your pay would disappear and you would keep 63% of your pay on average.

So for a million dollar level, the tax alone would go up to 37%, despite things like Social Security being capped at 147. Despite things like Pennsylvania and Medicare taxes being flat, a million dollar income household would have a larger proportion of their income in the highest tax bracket, thereby increasing the total amount throughout the year that’s paid in taxes.

So if you’re at a million dollar household income level, we would expect 37 just for taxes, plus an additional three to 4% in benefits. So you would keep approximately 60% of your pay and 40% of it would disappear throughout the year.

Other things to note is that you can expect for income earners above 147, which is the Social Security cap. You can expect a lower paycheck in the start of the year, and then once your gross income goes above 147, that Social Security tax stops.

And it’s almost like a pay raise that some people receive in the middle of the year, that 6.2% deduction stops, and that goes net into your pay. As a higher take home pay, some HR payroll systems will assume the incorrect rate.

We’ve seen this sometimes across the board at 24%. For example, maybe you’re a physician or executive that with your income you’re already at 37%. So if you find a big surprise at the end of the year, you owe 1020 or even 50,001 of the major reasons for this, if you’re a W two employee, is because.

A bonus or a restricted stock that was vesting that year was withheld. The taxes withheld were withheld at a rate that was not your effective marginal rate, which is wherever your income puts you before that bonus occurs.

If that’s the case, we recommend to audit your pay stub when a bonus does occur, just to make sure the correct withholding was made. If not, you can easily make an estimated tax payment online so there’s no surprises at the end of the year.

And then also for anyone that has 1099 income on top of their W two income that there’s no tax withholdings from the 1099, we would recommend to incorporate this in a tax analysis and make estimated taxes along the way to make sure that you’re avoiding any surprises and unnecessary interest charges.

The government charges 1% per quarter for taxes that are due that are not paid throughout the year. Thank you for your time, and please reach out if you have any questions.

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