Tax season… one of the least fun times of the year for many people. It consists of the extremely enjoyable activities of collecting all traces of income and certain expenditures in preparation to file your taxes for the previous year. Sounds like a blast!
Pretty much it means it’s time to true up your taxes with Uncle Sam. If you work for a company, they likely have been taking out taxes from your paycheck all year so that ideally what you ultimately owe is somewhat close to what’s already been taken out. For those that are self-employed, you’ve probably been paying quarterly estimated taxes to try to meet that same end.
If you happen to have paid more in taxes than you actually owe, congratulations, you get a nice refund from the government! If you’ve paid less than you owe, well, it’s time to true up, and hopefully you’ve set aside some money for that.
In order to find out what you actually owe in taxes for a given year, most people either wave their hands around and play with some tax accounting software, pay a professional to do it for them, or the rarity, fill it out on their own.
Be careful though, for whichever method you choose if you do it incorrectly you could face some serious fines or even jail time… what fun!
It’s for this reason (and a lack of fundamentally understanding how taxes work) that most people will pay a professional to do it for them, or go through a reliable and user-friendly tax accounting software company (like TurboTax or H&R Block).
I’m here to say though that taxes don’t have to be that difficult to understand. For most young people, especially those who do not own any real estate (this is 63% of people aged 25 to 34 according to this article), their taxes likely aren’t that complicated.
To show this, I’m going to walk through a step by step guide to formulating my 2019 taxes. I’ll even show a comparison between my 2019 and 2018 taxes for clarity and transparency, and to explain what differed (I already wrote about my taxes from 2015-2018 for those interested). I’m hoping this guide is helpful for anyone trying to formulate or confirm their taxes!
Figure Out Your W-2 Income
First off, I need to start with a little disclaimer:
I am not an accountant and do not provide tax or accounting advice. The below is for informational purposes only and should not be relied upon for your own situation. You should consult your own tax and accounting advisors before engaging in any transactions.
I also need to come clean that I too, in fact, use tax accounting software to file my taxes. You see, I take that threat of a big fine or jail time pretty seriously and even though I calculate my taxes on my own, I do check my work and officially file using online tax accounting software.
In addition, it’s not too expensive using certain sites (I used freetaxusa this year which was $0 for a federal return and $13 for a state return) which seems well worth it to play it safe and ensure my return is 100% correct.
To start this tax process off, you need to tally up how much money or “Gross Income” you made during the year. For those that work a W-2 job, your employer will send you an annual W-2 Form, that lists out your 2019 income for you.
It will also list out any pre-tax deductions you may have, including, but not limited to 401k/403b/HSA contributions, medical/dental premiums, transportation/child care benefits, etc.
To come up with your W-2 Gross Income, you take your Gross Income, and subtract out all employer deductions you have. Shown below is my W-2 Income calculation from 2018 and 2019:
As you can see, I had quite a large increase in salary (income) between 2018 and 2019, mainly thanks to a raise as well as a later promotion. The “Other” income is related to a $250 annual wellness reward my company gives out by meeting certain wellness target. The rest of it are from taxable achievement awards my company gives out if you are nominated for a job well done!
For deductions, I maxed out both my 401k and HSA in both years (my company contributes the rest of the HSA max for me which is not included here). Also listed are the medical and dental premiums I pay for coverage and insurance.
Add it all up and now you have your W-2 Gross Income! Let’s go to the next step:
Calculate Your AGI
The next step is to calculate your Adjusted Gross Income (AGI).
It’s in this section that you account for all the income and deductions that are outside of your W-2 job. If you don’t work a traditional W-2 job, you would actually just start here and skip the prior section.
The categories for additional income can include any self-employment income, real estate income, interest, dividends, capital gains/losses, and IRA distributions, among others. For younger people, this is probably all that is relevant, though there are many other categories to include.
The deduction categories include any IRA contributions (traditional, not Roth), student loan interest, and the self-employment tax deductions. As with the income, there are also many other categories here to include, but these are likely the most relevant to young people. Check with a tax professional (or search online!) to see if others apply for you here.
Here’s how my AGI calculation has turned out the prior two years:
My side hustle income was down in 2019 as I significantly stepped back on charging electric scooters after the terms and ease of it became much less favorable to my situation. Because I made less than $600 charging scooters, I didn’t receive a 1099-MISC form which usually details your non-W2 earnings, so this was all income I tracked myself.
Interest and dividends rose slightly, as I had more cash on hand (and parked my cash in a high yield online savings account), as well as more money in investments in my Brokerage. The rest of my investments are all in tax deferred (401k, HSA) and tax free (Roth IRA) accounts so their investment income doesn’t show up on my taxes.
I also haven’t sold any stocks that would lead to a Capital Gain/Loss (though I will in 2020), nor taken a distribution from my 401k that would lead to a taxable event as current year income.
As for deductions, I choose to contribute to a Roth IRA instead of a Traditional IRA, so I can’t take a deduction for those contributions. I luckily also don’t have any student loans to account for either and thus don’t have a deduction there.
We’ll get into this more in a later section, but what’s interesting (and unfortunate) about having a side hustle (or your own business) is that you need to pay self employment taxes on your earnings.
You see, usually your employer covers half of the 15.3% you pay in FICA taxes (for social security and medicare) and you only pay 6.2% and 1.45% of your income for each that are taken out of each paycheck. When you don’t have an employer, you’re on the hook for all 15.3% :/
They at least allow you to get a tax deduction on half of the total self employment taxes that you owe.
Since I made less than $400 on my side hustle in 2019, I actually did not have to pay self employment taxes at all, which is why there is no corresponding deduction for it.
Total Federal Income Taxes Owed
Finally we get to what you actually owe on your taxes.
Here is where we take the AGI you just calculated in the previous section, and apply a couple last deductions before getting to your actual taxes owed.
Here is how my federal income tax owed came out the prior two years:
As I made a lot more money in 2019 than I did in 2018, it only makes sense that I paid a lot more in Federal income taxes. In order to get to this final number, there are a few calculations you need to make.
First, if you have enough qualified expenses that you can “itemize” your deductions, here is where you would do that. Most young people don’t have enough expenses like this for it to make sense, so taking the Standard Deduction would likely make the most sense here.
Exemptions are a now extinct part of the tax code (they roll into the Standard Deduction now), so I should probably get rid of that line!
The QBI deduction only relates to you if you have side income from a business you own or a 1099-MISC form. In some cases you may qualify for a nearly 20% tax deduction. To calculate, you subtract your self-employment tax deduction from your self-employment income (both in prior section), and multiply by 20%. You also take your Section 199A Dividends (found on line 5 of your 1099-DIV Form) and multiply that by 20% as well.
For me this was $323 – $0 = $323; $323 * 0.2 = $65; $14 * 0.2 = $3; $65+$3 = $68
Finally on to the taxes owed calculation! In order to correctly determine your income taxes owed, you need to remove your qualified dividends (found on line 1b of your 1099-DIV form) temporarily as they are taxed differently than normal dividends. While regular dividends are taxed as normal income, qualified dividends are taxed at 0% if your AGI falls within the 10% or 12% marginal tax bracket (2019 single filers shown below), or at 15% if you are in any other bracket.
In order to calculate your Federal income tax owed (before credits), you will need to utilize the above table to do the math. Because we have a marginal tax system, your money is taxed differently depending on how much you make.
Here’s how I came to calculate my $8,647 owed:
The first $9,700 (first line on above table) is taxed at 10% (9,700 * 0.1 = $970.00)
The next $29,775 ($39,475 – $9,700) is taxed at 12% ($29,775 * 0.12 = $3,573.00)
The last $18,450 ($57,925 – $39,475) is taxed at 22% ($18,450 * 0.22 = $4,059.00)
Don’t forget to add back those qualified dividends! The $303 of qualified dividends is taxed at 15% since I am in the 22% marginal tax bracket ($303 * 0.15 = $45.45).
Add those all up and round to the nearest dollar ($970.00 + $3,573.00 + $4,059.00 + $45.45) and you get $8,647. The exact amount I owed!
One interesting you may have noticed is I used $57,925 in the last section, instead of $57,926 as shown in my table. Well, when your taxable income is less than $100K, you actually use the IRS tax tables, which averages your income ending in $25 or $75 increments (whichever you are closest to) to make the calculation. It was only a dollar off this time, but sometimes its a big change!
Lastly, if you qualify for any credits, this would be the time to add these in and subtract from the total income owed we just calculated. This is different from a deduction (which lowers your taxable income). Credits are much more valuable!
The ones most relevant would be the child tax credit (if you have one), foreign income tax credit (for any income made overseas) and the retirement savings contribution credit (there is an income threshold to qualify).
I didn’t qualify for any of these so $8,647 was exactly what I owed, which worked out to 12.27% of my income. Not anywhere near the 22% tax bracket I was in!
Finally, while it’s not shown (since I didn’t owe this year), for those with self-employment income above $400, you’ll need to pay self-employment taxes.
To calculate this amount you take your net earnings and multiply by 92.35% (here’s the explanation behind this number if interested), then multiply that number by 15.3%.
You Did It!
Once you have those calculations completed you should be all set! At its most basic level, this is how you can calculate your taxes without getting lost in the thousands of pages of tax code. Perhaps you could even take these calculations and create your own tracker for your situation!
Of course, if you have a more complicated tax situation (like if you own real estate, have foreign earned income, have healthcare through the state, etc) this could make things much more tricky. Most young people, especially those with a W-2 job, don’t have nearly as complicated a tax situation as it initially seems though.
If all this tax jargon was just too much for you, I hope at the very least the one thing you took out of this is just how powerful pretax deductions can be to lowering how much you pay in taxes. If you noticed, I made over $92,000 in gross income last year, but only paid taxes on just over $70,000 of it by taking advantage of the opportunities given to all of us in the tax code.
As I’ve said before, if you want to win the game, you need to know the rules. These are some really useful rules to know.
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What other methods do you use to track your tax liability? Did I miss anything that would be useful to discuss? How do your taxes compare? Let me know in the comments any other questions you may have!