So far we’ve written about the kind of things we all spend our money on – housing, transportation, food, the usual. What we haven’t posted about yet though is the area that for many consumes the largest percentage of our money – taxes! When trying to optimize your finances, you can’t leave this large chunk as a “great unknown” that only gets clarified once a year in April when you sit with your tax preparer or log into Turbo Tax. Sound tax planning by learning how to estimate your taxes is key to a stable financial house.
Once you understand just a few key areas, you will be able to estimate your taxes owed each year, and manage your month to month cash flow accordingly! We have included a link below to the spreadsheet that we use to calculate how much federal income taxes we’ll owe each year. (we live in Florida, one of nine states with no state income tax – hooray!)
This post is NOT a comprehensive resource on taxes. Taxes are a complex issue that I will never be qualified to write about. The reason for this post is to highlight the most helpful things we have learned on our personal finance journey, and to share our Excel spreadsheet to help you estimate your taxes. You can download it for free if you just scroll to the bottom!
Our experience
A quick trip down memory lane sets the stage for how important it is to be on top of your taxes. After we got married, we changed our tax filing status from 2 individuals each filing Single, to Married Filing Jointly. Because we both worked full time, and had no substantial deductions of any kind (i.e. mortgage interest, dependents), we had a rude awakening the first time we filed together.
We owed $4,794 in additional federal income taxes! What??? I remember my wife and I, sitting in the cramped room across the towers-of-paper-piled desk from a very tired and very bored accountant, looking at each other with eyes that said….”I mean, I love you, but I didn’t know this marriage was going to cost me!”
Sometimes we are slow learners
We had some time before April 15 that year so we saved the money, paid the IRS bill, and moved right along. After that we changed nothing in our finances, but hoped the result would somehow be different a year later. (definition of Insanity?) Well, was it different next year? Nope! In our second year of filing together, we owed $5,848! The tax man was really putting a damper on our vacation plans! I kid about vacations, first world problems, but what if we had needed that savings to pay a medical bill, or even, next month’s rent? What if we couldn’t come up with the money by the deadline and fell into debt with the IRS? We needed to remove that kind of unpredictability from our life. So began the education we will now share!
Here are the Top 5 things we wish we knew, presented from most basic to more complex.
1. We Wish We Knew – tax brackets
The federal income tax bracket taxes your money on a graduated scale. For example, you may have heard “I’m in a 22% tax bracket”. That does not mean that if that person is single and earns, say, $50,000, that 22% of that, or $11,000, goes to federal income tax. It means only the portion of their $50,000 that lies in the 22% bracket gets taxed at that rate. The rest of their income gets taxed at lower rates.
Using Table 1 below, let’s break it down. For that $50,000 taxable income single filer, the first $9,700 of the $50,000 is taxed at 10%. Then everything above $9,700, but below $39,475 is hit at 12%. Only what’s above $39,475 is truly taxed at 22%. For that person it works out to $6,858.50 of tax, which is a nominal rate of 13.7%. A far cry from 22%! (See Table 1 and Table 2 for the 2019 brackets)
Just having a basic understanding of the concept of brackets is a good start to understanding how to estimate your taxes. And you don’t need to memorize the rates and the min and max for each rate, because they do change from time to time.
2. We Wish We Knew – estimate Social Security and Medicare taxes
These two items appear along with federal withholding taxes on your paycheck. They get grouped into your overall “taxes” in that they all reduce your takehome pay, but these two are much different than federal income tax, which is what we are trying to estimate. Often referred to as FICA taxes, or payroll taxes, these amounts are taxed the same for everyone, regardless of how much income they make. This makes them easier to calculate. Together, they total 7.65%, which is broken out as:
- Social Security – 6.2%
- Medicare – 1.45%
Key items to note
- Another 7.65% for these same taxes is also typically paid by your employer, for you. The real total cost is 15.3%, but your employer deducts half from you, contributes the other half, and sends it to the IRS on your behalf.
- The social security tax has a wage base limit of $132,900 in 2019. This means if an individual earns more than that, everything on top of that number isn’t subject to the 6.2% tax.
For our purposes of estimating our federal income taxes, we won’t get further into FICA taxes on this post or in the spreadsheet. But it’s really helpful to not group these taxes in with income taxes. If you want further detail, check out this article.
3. We Wish We Knew – estimate taxes annually
This was probably the biggest “Aha Moment” for me. Anyone who gets a paycheck is aware that on each, you will have federal income taxes “withheld” (removed). The US Government requires your employer to do so. We’ve all heard something like “Oh my paycheck was $3,000, but after taxes I only got like $2,000…” The number that really matters is not on a single paycheck, but the sum of all those monthly withholdings – at the end of the year. I missed the big picture by getting in the month-to-month deductions from my check. All the money you “pay in” throughout the year is deducted from your true tax liability, and then one of these applies:
- you owe the IRS (like us in the earlier example), or
- the IRS owes you (refund).
- (or you settle to exactly $0.00….let me know if you have achieved this so I can have you write the next article….)
Your goal is to owe the IRS nothing, and here is why.
You Owe Them. Owing your brother a few bucks? “Hey, I’ll Venmo you next month”. Owing the US government, with their collection agency the IRS ready to rumble? No sir – you do not want to be in debt to the government. They will come collect. AND they charge interest on unpaid amounts to the tune of 3-5%, compounded daily, AND they can even garnish your wages. Try winning Employee of the Month with that overshadowing you.
They Owe You. (Refund). If THEY owe YOU money, that means you loaned them money throughout the year, and they are now returning it to you, because they took too much. Getting a refund may feel good, but it’s usually a sign of improper tax planning. Wouldn’t you rather have had that money in your hands month after month? It’s like giving the government an interest-free loan!
After we better understood this component, the next one really allowed us to make some good decisions.
4. We Wish We Knew – you can control how much you pay during the year
Back to us. After Year 2 and Year 3 of our increasingly depressing “how much do we owe this year” experiences, we sought professional tax advice mid-year. A friend referred us to a new CPA, and for a fee he forecasted how much tax we would owe when the year was done. This was in 2015, and was one of the first steps that as a couple we really took to getting a better handle on our overall finances.
How to adjust your withholding
In order to adjust your withholding up or down, go to your paycheck/tax portal and modify:
Tax Withholding. Increase the dollar amount of your tax withholding when the spreadsheet says you are forecast to owe money at the end of the year. Yes, this means purposely pay more tax per paycheck.
Allowance Exemptions. Increase your quantity of exemptions when the spreadsheet says you’re getting a refund at the end of the year. This will result in less tax withheld per paycheck. Initially I associated this ‘exemption’ count with how many children I had (zero) and was hesitant to change it. Was it fraud? Turns out, that’s not what it means, and this is completely legal, as this reference from Zacks.com explains:
“The IRS allows you to change the number of your allowances as frequently as you need to, so that you can keep the withheld tax amounts from your paychecks closely aligned with your year-end tax liability.”
finance.zacks.com
Once we understood this, we were able to adjust our tax withholding and allowance exemptions to avoid another large bill. We were learning how to estimate our taxes! Thinking ahead, I also had the CPA share the spreadsheet he used to forecast our rest of year taxes. I have been using it regularly ever since, and it has given birth to the version you can download below.
5. We Wish We Knew – how to reduce tax liability
Having fun yet?! We’re almost there!
The tax code offers a number of “tax shelters”, or things you can do to exempt portions of your pay from income tax. These shelters “steer” people into making certain types of decisions that have the combined effect of A) reducing your taxes, and B) overall being a positive thing in your life. (being forced to save money, for example, is good). Once you know the basic strategies, you can sprinkle them into the spreadsheet and see what they do for you. Here are a few:
Things that can reduce your tax bill
- Have Kids! $2,000 tax credit per dependent child (not that this is the reason to have kids, of course…)
- Contribute to a retirement account. 401k, 403b, 457, Traditional IRA, or similar. Every dollar you put into one of these is a dollar you defer paying taxes on until retirement age. Do you know which accounts are available to you in your workplace? (Note – Traditional IRA’s have income limits to get tax deductions now. Roth IRA’s offer a tax benefit later when you withdraw)
- Contribute to a Health Savings Account (HSA). You can contribute tax-free, grow tax-free, and withdraw tax-free for medical expenses. A triple advantage! We love this account.
- Itemized Deductions. With the Tax Cuts and Jobs Act of 2017, itemizing became less popular, and now an even greater majority of taxpayers use the Standard Deduction. Itemizing and saving money is still achievable for some, but far less people do it now.
- Do part-time consulting work. Or, a “side gig.” Many of your expenses can become tax deductible, including computer equipment, subscriptions, even part of your rent or mortgage!
Estimate Your Taxes – with our Tax Planning spreadsheet
Our Tax Planning spreadsheet helps you estimate your taxes to see if you’re on pace to owe additional taxes, get a refund, or the ultimate goal, balance out to 0.00. Other features:
- A complete step by step instruction guide
- Options for Married Filing Jointly, or Filing Single.
- “Pre-loaded” with sample incomes. Sample Income 1 earns 77k, and Income 2 earns 66k. Just read the instructions tab, insert your actual numbers, and you’re off!
- Using this spreadsheet, last year I was within $100 of paying “exactly” our tax bill! This year I am trying for even closer. (nerd alert!)
- Allows Married Filing Jointly to estimate how much “each” spouse owes. The IRS looks at your incomes as 1 combined total, but we found it helpful to know how much tax should be coming out of each spouse’s paycheck. Optional, but useful.
- Link to our Tax Planning spreadsheet
Congratulations! You read an entire blog post about how to estimate your taxes! Feel free to reward yourself with a glass of your favorite beverage. Let us know if there’s a particular problem you’re facing that you’re looking for help with!