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Tax Season Is Almost Over – What We Can Learn?

Tax Season Is Almost Over – What We Can Learn?

April 01, 2023

So, income tax season is almost over (for this year). What now?

If you’re like many people, you’re just happy to have finished preparing your taxes with TurboTax (or the equivalent, if you’re a DIY-er and that’s your vibe), or grateful for a professional CPA or paid tax preparer who takes the responsibility for “figuring out where everything goes” with minimal input from you.

But before we put away the calculators and green eyeshades, I think there are some key takeaways – important “tax” insights we can learn – to help us benefit from all the efforts and activities that went into preparing our tax returns.

The Most Important Tax – Total Tax

First, I want to draw your attention to “what really matters” about taxes, and I don’t think it is the size of our refund, or whether we get a refund at all. Many people enjoy receiving a little “bonus money” every spring. Others may have been told that a tax refund (especially a large one) is a just a (large) interest-free loan that you made to the IRS, and that’s bad. So, if I don’t want to focus on the refund or payment due with our tax returns, what should we focus on?

I believe the place to focus is on Total Tax (Line 24 on the 2022 Form 1040). Found on your federal tax return, this is the amount of total federal income tax calculated – from all our sources of income, adjusted for deductions, exemptions, tax credits, phase-outs, phase-ins, preferential rates, surtaxes, etc. – and that we paid (will pay) in income taxes to the US government last year (throughout the year, netted out with a refund/taxes due this year, alongside filing the tax return itself). If we live in a state with its own state income tax, then there is a similar “Total Tax” that we paid (will pay) in state income taxes to our state government taxing authority. Finally, to truly understand the total amount paid in “taxes”, I think it is also important to remember the amounts we paid in FICA taxes throughout last year – Social Security and Medicare (6.2% up to wages of $147,000 in 2022 for Social Security, and 1.45% with no limit for Medicare). These FICA taxes do not show up on our federal or state tax returns, although they do appear on the “paystub” we receive each pay period along with the amounts of federal and state withholding, etc. I am sure that many of us can still remember the first time we received a paycheck, from our first job, and the disappointment we felt looking through the paystub and wondering who “FICA” was, and why he was getting some of my paycheck!

So, putting it all together:

Total Tax = Total Federal Income Tax paid + Total State Income Tax paid + FICA Taxes paid.

Tax Brackets, Marginal and Average (Effective) Tax Rates

As a former high-school math teacher, I know that not all of us are good with fractions and percentages. Nevertheless, ratios (including fractions and percentages) can be helpful in working with numerical and financial data, when we are trying to compare values of different sizes. For example, if the “Total Tax” you paid this year is $25,000, is that a lot? Did you get a good deal? It’s hard to know at first glance without some context, or a “ratio”. One simple ratio calculation that many people will see on their TurboTax output (or from another program, or from their tax preparer) is the “average tax rate” paid, sometimes this is also called the “effective tax rate” paid. What is it? We know from the formula above what is our Total Tax paid (from all sources – federal income, state income, and FICA), and this will be the numerator in our ratio/fraction. What should be the denominator (the “bottom” number)? According to various websites (Investopedia, Bankrate.com, etc.), it depends. Some use “Total Income” (Line 9 of 2022 Form 1040), others use Adjusted Gross Income (a commonly used definition for “income”, found on Line 11 of 2022 Form 1040), while others use Taxable Income (Line 15 of 2022 Form 1040). They will usually provide different answers, as they represent different ratios (and are usually expressed as percentages):

  • Average (Effective) Tax Rate paid on Total Income = Total Tax / Total Income
  • Average (Effective) Tax Rate paid on Adjusted Gross Income (AGI) = Total Tax / AGI
  • Average (Effective) Tax Rate paid on Taxable Income = Total Tax / Taxable Income

What I find interesting about the last one – average tax rate paid – is that it is truly a “blend” of the various tax brackets in our tax system. Some states use a “flat rate” to determine income taxes in their states; others have a “progressive” tax system like the federal government (IRS). Medicare uses a flat rate without a cap on taxed income; Social Security (employee portion) uses a flat rate, but only up to the annual limit. The federal income tax system is “progressive” and is composed of a number of “tax brackets” – the lowest bracket = a 10% rate for singles (on taxable income up to $10,275 in 2022), then a 12% rate for singles (on taxable income above $10,275 and below $41,775), a 22% rate (on taxable income above $41,775 and below $89,075), and so on, all the way up to a tax bracket with no ceiling and a rate of 37%.

There are similar brackets for married couples filing their taxes together (jointly), married couples filing separately, heads of household, and qualifying widows. When you pay taxes on income in “buckets” at the various rates, this is how you end up with an average rate that is a blend of the taxes paid at the buckets’ various rates.

The Marginal Tax Rate for a given taxpayer is simply the final (highest) “tax bracket” where you paid some income taxes in a given year. It represents the tax rate on the “next dollar of taxable income” that you would pay in additional taxes if you received another dollar (or more) of income, and/or the tax reduction from “one dollar less of taxable income” if you should find a way to reduce taxable income by one dollar (or more). Most notations of “marginal tax bracket” usually only include the applicable federal income tax bracket, but it can be extended by adding the marginal state tax bracket, along with the flat Medicare tax, and the employee portion of the Social Security tax, if that is applicable for a given level of wage income. This is an important piece of information in financial planning but is often not provided by tax preparation software or individual tax returns.

Due Date for Filing Taxes

Then, while taxes are “normally” due each year on April 15, you can also file for an extension of time to file your tax return the simple filing of a form. Yes, it’s true – if you file Form 4868, the IRS will give you an automatic extension to file your tax return until October 15 of that next year. There is a caveat – at the original filing due date, you must make a payment of the taxes you expect to owe when the filing is eventually completed. Any shortfall will be owed at that time, along with taxes and possible penalties for underpayment. And yes, any excess payment made alongside filing for an extension will be refunded to you.

What is different this year, residents of many states (including most but not all counties in California) have an automatic extension of the filing deadline and the due date for payment of taxes owed. According to IRS Notice CA-2023-03, due to extensive winter storms, flooding, landslides and mudslides, residents of 54 California counties will have until October 16, 2023 to file their 2022 federal and state tax returns and make any payments for additional taxes owed.

The Best Time for Tax Planning

Finally, going through the process of preparing taxes each spring reminds us that the time to have made any changes that would affect that tax return, with very few exceptions, expired at midnight New Year’s Eve along with the previous year. Once the calendar turned to a new year, all of us “calendar year” taxpayers can no longer do any meaningful “tax planning”. The time for tax planning (for example for the year 2023) is during the calendar year 2023, prior to December 31, 2023.

There are many ways to “plan” for income taxes. In any given year, for example, you might be able to actively manage your taxable income and spread it out over several years instead of one (this is especially true with recognizing investment income, or if you expect a spike in regular income), thereby keeping a lid on your marginal tax rate. Or you can “bunch up” your deductions in order claim an itemized deduction that is significantly larger than your standard deduction, rather than using an itemized deductions total amount that is smaller than, or only slight larger than the standard deduction amount. There are many other opportunities that you can learn about on the internet (as a DIY-er), or by working with a competent financial professional. Working with a professional who can engage in meaningful tax planning with you will “optimize” the taxes you will pay over multiple years, and especially as you prepare for and launch into retirement.

If you’d like to see whether we should work together to plan effectively for your future taxes and your other financial planning needs, I’d love to talk to see if I can be helpful. Please send me an email or give me a call: mike@wealthmatters.com and/or (707) 428-5500.

About Mike

Michael Hathaway is a fiduciary financial advisor at Epsilon Financial Group, Inc., an independent, fee-only wealth management firm. Mike has worked in the finance industry for more than 20 years and brings a wealth of knowledge and experience in sophisticated financial planning to help his clients make sound financial decisions. He is known for caring deeply for his clients’ well-being, being compassionate, and thinking creatively to help clients attain their financial goals. He prioritizes building long-term relationships and takes the time to listen, understand, and explain so that his clients feel confident in their financial plan. Mike is a CERTIFIED FINANCIAL PLANNERTM, Chartered Financial Analyst® (CFA®), and Accredited Investment Fiduciary® (AIF®) professional; he has a bachelor’s degree in cybernetics from UCLA and an MBA in finance and accounting from the University of Virginia. When he’s not working at Epsilon, you can find Mike enjoying anything related to exercise and fitness. He especially loves activities in the great outdoors, such as camping, hiking, snowshoeing and mountain biking. In the fall of 2016, Mike successfully climbed to the top of Mount Whitney in a single day, the highest peak in the continental United States. To learn more about Mike, connect with him on LinkedIn.