Big Law 101: Income Taxes
In continuation of the Big-Law Associate’s Financial Playbook Series, let's take a closer look at how federal, state, and local taxes play a role in your take home pay and what to expect going forward. For the purpose of this blog post, we'll solely be focusing on income taxes. We'll cover investment related taxes such as tax deductions, tax deferred, tax free, short/long term capital gains, and how to maximize tax efficiency in depth in a separate post.
Before we get into budgeting, savings, investments and some of the more “exciting” aspects of finances, we need to understand how taxes work, where they’ve been historically, and how to plan for them in the future.
To start, let’s first revisit what taxes are in a nutshell and why they exist. Taxes are a mandatory payment typically imposed and charged by federal/national, state and local governments on individuals or businesses. They are collected to help cover the costs of general government services, goods, and activities. They help pay for things that society benefits from such as the roads you drive on, to law enforcement, to the salary of the President of the United States.
These taxes aren’t optional and trying to hide or outrun them can result in severe penalties/fines and ever jail time. Google “tax evasion” and I’m sure you’ll find a number of high-profile cases that didn’t end well for the individual. 96 percent of Americans believe it’s your civic duty to pay taxes, so the best thing to do is get a basic understanding of taxes so that you can pay them on time, with minimum stress and pain — financial or emotional.
For this post we’ll focus on federal taxes as it affects everyone reading this. State & local taxes will vary for everyone depending on the state you live in and the municipality. For example, there are currently 9 states that do not have state income taxes (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming). If you’ve ever wondered why so many people plan to retire in Florida – aside from the warm sun and year-around beach access, a big reason is because there are no state income taxes, which means less money to the government and more money for retirement.
So, let’s take a look at the 2023 Federal Income Tax Rates:
US Federal Income Taxes are progressive. What this means is that additional income is taxed at a higher rate. Tax rates are also marginal which means all of your income is not taxed at the same rate. Income is divided into different brackets that have different tax rates as you can see above. You can think of these brackets as a series of buckets, each bucket holds a certain amount of money and is taxed at different rates. The federal government determines the size and amount in each bucket and will usually adjust every year.
Taxes in Practice
Let’s provide a quick example. Let’s say you are single filer and earn a gross adjusted income of $200,000 for 2023. The first $11,000 of income would be taxed at 10%, the next $11,001 to $44,725 would be taxed at 12%, from there the next $44,726 to $95,375 at 22%... and so forth until we hit the $200,000 number. In this example, your effective tax rate (total tax paid divided by total gross income) would be only 19.2%, not 32%!
Now let’s take a closer look at how this looks in one’s paystub and what it means going forward.
Will tax rates go up or down in the future?
I’ll touch on this quickly because I think it’s important to take a look at where historical tax rates have been in the United States for the top marginal rates. While nobody has a crystal ball on where tax rates are going in the future, by taking a look at the historical chart – this tells us we are actually in a fairly low tax rate environment currently. Surprised? I think most people would be. The top marginal average rate is closer to 58% historically – currently the top marginal rate is 37%. The point here is to remind everyone that federal tax rates can vary dramatically and have been as high as 90% in the 1950s!
Budgeting & Planning
Let’s take a closer look at this chart above for a single filer who lives in a high tax-rate area, New York City. NYC is a wonderful place to live – it has unlimited restaurants, bars, attractions, beautiful parks, skyscrapers, etc. It is also one of the most expensive places to live, not only in America but in the World. My point here is that depending on where you live, taxes can take up a massive chunk of your income. In the example above this individual pays nearly 32% of their income to federal, state, and local taxes (19% effective to federal, 5% FICA, 5% State, 3% local). It’s extremely important to plan and budget accordingly. After taxes and contributing to retirement accounts this individual’s disposable income approx. $100,000 which they will need to divde amongst rent, food, entertainment, travel, gym memberships, phone, etc.
For those that may feel tight month to month, I advise to first start with a budget sheet and understand what your true “take-home pay” after taxes/other deductions are. From there, you can create a realistic budget for your disposable income.
The Bottom Line
Anyone who earns income is responsible for paying income tax! It’s a civil duty. It’s extremely important to understand your tax rate and how income taxes will affect your total take home pay (net income). It’s important to budget accordingly based off your net income (not gross!)
Please remember this is not direct tax advice but rather a simple guide on how tax rates work. You should always consult a licensed CPA or tax advisor if you have questions relating to filing taxes or taxes in general. All examples are hypothetical and are used for illustrative purposes only and are not representative of actual results.
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