Example: Calculating Federal Income Tax for Dr. Jones Using Brackets

To make it simpler to understand, let's break down Dr. Jones' income and tax rates as he steps through each bracket (row in the chart above):

1. The first $22,000 of Dr. Jones' income is bracket 1 - taxed at 10%, resulting in $2,200 in taxes.

2. The next $67,449 (from $22,001 to $89,450) is taxed at 12%, resulting in $8,094 in taxes.

3. The next $101,299 (from $89,451 to $190,750) is taxed at 22%, resulting in $22,286 in taxes.

4. The next $109,249 (from $190,751 to his income of $300,000) is taxed at 24%, resulting in $26,220 in taxes.

Dr. Jones made $300k, but he paid taxes in each bracket until he reached his actual income. So, Dr. Jones paid 10% on some of his income, 12% on some income, and he keeps stepping up.

Adding up the tax amounts from the different brackets, we get $2,200 + $8,094 + $22,286 + $26220 = $58,799 as Dr. Jones' total federal income tax liability, but that isn’t quite what he will pay.

Standard Deduction and Itemized Deductions

Taxpayers can reduce their taxable income by taking deductions. There are two options for taking deductions. Dr. Jones (and all taxpayers) can take a standard deduction or itemize his deductions.

The standard deduction is a fixed amount that varies based on filing status. In our example, we assume the standard deduction for married couples filing taxes jointly is $27,700. If Dr. Jones uses the option for a standard deduction, he simply subtracts $27,700 from his income.

His income of $300,000 minus $27,700 (standard deduction) = $272,300. With a standard deduction, this is now Dr. Jones’ “taxable income.” This is the amount that he will actually pay taxes on.

To calculate the amount he pays in income taxes, he then runs through the tax bracket example again, stopping at his taxable income of $272,300. Here is what that looks like:

$2,200 + $8,094 + $22,286 + $19,572 = $52,151

The standard deduction is a deduction that all taxpayers can use, and it gave Dr. Jones a savings of $6,648.

Alternatively, taxpayers can itemize their deductions, which include expenses such as mortgage interest, state and local taxes, and charitable contributions. Dr. Jones would only itemize deductions if the total of his deductions was more than the standard deduction of $27,700.

Dr. Jones cannot itemize his deductions and use a standard deduction. He has to choose one or the other.

If Dr Jones has mortgage interest of $8,000 and he donated $30,000 to GRACES (his favorite charity), his total deduction would be $30,000. In this case, Dr. Jones would itemize his deductions because the total is more than the standard deduction.

For this scenario, Dr. Jones would subtract his itemized deductions of $30,000 from his $300,000 total income to arrive at $270,000 as his “taxable income.”

He would do the same addition walking through the tax brackets, but he would stop at $270,000, as that is his taxable income.

His income tax liability with his $270,000 taxable income would be: $51,599.

Understanding deductions is the first step in choosing the right tax strategies.

To attain true wealth, the focus has to first be on lowering taxable income, or actually keeping what you earn.

This is done through deductions.

For this example, we use 2 very basic examples of itemized deductions: mortgage interest and charitable donations.

The tax guide is full of other ways to maximize more advanced deductions that can dramatically lower taxable income.

This is the beginning of understanding the federal income tax brackets. You step up through the brackets, paying a higher percentage the more your income climbs.

The amount of money you make in a year is your gross income. You then subtract deductions from your gross income, which gives you taxable income.

This is a very basic explanation of how taxes are calculated, and there are more details that go into specifics, such as above the line and below the line deductions. But, the purpose of this article is to understand taxes, not to be an expert.

The simple equation for taxes is (Income - Deductions) x “tax rates” = Taxes Paid

To attain True Wealth, you must lower the taxes paid. There are only 2 ways to do this:

Lower your income or increase your deductions.

Lowering income has never been a good strategy for wealth creation so the focus must be on increasing deductions.

Executing on the strategies in the Tax and Investment Guide is how you bring the Vision for your financial future to life.

To quickly calculate your income tax liability, you can use an online calculator like this one.

Return to the Tax and Investment Guide here or continue to learn about tax credits.

Tax Credits

Tax credits are another way to reduce tax liability. Unlike deductions, which reduce taxable income, tax credits directly reduce the amount of tax owed. Examples of tax credits include the Child Tax Credit, the Earned Income Tax Credit, and the American Opportunity Tax Credit.

Example: Reducing Tax Liability with Tax Credits

Let's assume Dr. Jones is eligible for a $2,000 Child Tax Credit. He would subtract the tax credit from his tax liability to determine the final amount of tax owed:

$52,151 (calculated tax liability) - $2,000 (Child Tax Credit) = $50,151 (final tax owed)

Tax credits are beneficial because they are a direct subtraction from the amount of taxed owed. However, most tax credit “phase out” for high-income earners making them ineligible to use any credits.

It is important to understand how tax credits work, but there are fewer options available to increase tax credits compared to the numerous ways to increase tax deductions.

The Tax and Investment Guide provides detailed strategies to increase deductions, in some cases bringing taxable income all the way down to $0.

For the purpose of simplicity, state and local taxes are not included in this article.

You can learn more about state income taxes on the Tax Foundation Website.

Inflation

There is one more “tax” that will steal your money. Inflation is known as the Stealth Tax.

Although it is not a tax that you pay, it is a devaluation of your money.

In the simplest example, let’s assume Dr. Jones earns an income of $300,000, but inflation is 6%.

Dr. Jones can only buy $282,000 worth of goods, meaning the stealth tax of inflation stole $18,000 from Dr. Jones.

Final Tax Example

Let’s walk through a final example that shows a likely possible example for Dr. Jones.

Dr. Jones earns an income of $300,000 (he is a top 2.5% income earner in the USA!)

Now, let’s see how much he actually gets to keep:

He didn’t use strategies in the Tax and Investment Guide so he only has a standard deduction of $27,700, reducing his taxable income down to $272,300. This is the amount he will pay taxes on.

Dr. Jones steps through the tax brackets to calculate how much he owes in taxes.

His total tax bill is $52,151.

From the $300,000 that Dr. Jones earned, we subtract his tax bill of $52,151 to find that he only keeps $247,849.

For that year, inflation stole 6% from Dr Jones so he has to reduce this number by 6%.

After inflation, Dr Jones can only buy $232,977 worth of goods.

After years of medical school and residency income, he finally makes $300,000, but after all of that, he really only has $232,977 worth of value.

Taxes stole $67,022 from Dr. Jones.

Dr. Jones lost more of his money to taxes than many American make in a year.

This loss does not even include potential state income taxes, local taxes, property taxes, gas taxes, sales taxes, and many more.

“It’s not how much money you make, it’s how much money you keep. “ -Robert Kiyosaki

Dr. Jones should be very proud that he is in the top 2.5% of wage earners, but…

Dr. Jones will never achieve his True Wealth Potential giving away $67,022 each year via taxes.

If Dr. Jones only implemented a few strategies and cut his tax bill in half, he could take the $30k that was previously stolen by taxes and invest it at 10%. If he does that for only 15 years, he will have $1.21 million more dollars.

Dr. Jones has two options with his new tax knowledge:

1. He can keep paying the the government $67,022 in taxes every year.

2. He can implement effective tax and investment strategies to cut his tax bill by $30k for example. He then takes that $30k and reinvests it, creating $1.2 million dollars of wealth for his family over the next 15 years.

The best news for Dr. Jones is that he doesn’t even have to earn any more money. He just needs to implement a strategy so that $30k goes to his investment fund rather than where it was going, taxes.

It is time to achieve your True Wealth Potential!

Let’s get back to the Tax and Investment Guide.