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Barms

Primer on how tax deductions work

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You have “earned income”.   Most people get a paycheck.   We call those people “W2 earners”.   You get a gross wages number at end of the year.   That gross wage starts being applied to a thing called marginal tax brackets. You owe zero taxes on the first part of gross wages call it 0 to 19k.  Then from like 20k to 40k it’s like 10%. Then from 40 to 60k it’s like 22% and 5 more buckets all the way up to 39%.  You add up all those increments and that is how much officially the Fed wants from your gross wages.  That all in combo is your effective tax bracket.   Just for this primer lets say you have 100k in gross wages and your effective bracket worked out to 29%.   You earned 100 but only kept $71.   $29 goes to Uncle Sam  

but wait,  there are things you pay for in life that that you can apply to REDUCE your gross wages.  Call that “adjusting” your gross wages.   Have kids?  Reduce a couple of grand, have a mortgage? Reduce your gross wages by the amount of mortgage interest you pay.  Pay property taxes?  Reduce by that.  Pay state INCOME taxes?  Get more reduction for that from the Fed the line is called “taxes paid to other jurisdictions”.   Give to charity?  Reduce by that too.

So a lot of money laid out can “adjust” your income.  Let’s say the sum of the kids, mortgage; prop taxes, state taxes and charity is.   $11k.   So your wages are not $100k they are $89k.   Let’s assume same brackets as above 29% effective.  You owe $11k x 29% LESS in taxes owed becsuse of deductions.  $3 grand!

next, you look at that $11k adjustment and you say man life is good with these deductions,  but actually the Fed gives you an automatic minimum deduction if you choose.  It’s currently $12k.   So all those items you worked so hard tallying up to get to $11k is still not as beneficial as taking the STANDARD $12k

now, if the sum of your kids mortgage property local income and charity is say $25k then you pass on the standard and you submit an ITEMIZED deduction list that brings your $100k down to $75k.   Now let’s say that new smaller amount makes your effective bracket be 25%.   You earned $100k and keep $75k of it. 

What if you had 7 kids and your property taxes were $20k and your mortgage interest was $20k and you made $10k in charity payments.   Your adjusted wages is now $50k.   $50k in wages is only like the 22% effective rate.   So your gross wages is $100k your adjusted is 50k you only owe 22% on $50.   You earned $100 you keep Ike $88 of it.   So massive property taxes and state income taxes and 7 kids is great right?  Pay less taxes!   Not so fast.   The Fed does not let someone have massive deductions relative to their gross wages.  They ballpark by putting in a floor effective rate.  It’s about 26% effective rate.  So you THOUGHT you were gonna ow just 22% on 50k but the floor was 26% on the $100k.  They are making you calculate your taxes owed an ALTERNATIVE way.   You now owe $26k in taxes on your $100 not $12.

anytime that alternative is triggered it doesn’t matter a single solitary cent how many kids you have, what your property taxes are etc.  it doesn’t change your 26% floor whatsoever.  If you were AMT only two things adjusted your wages your mortgage interest and your charity.  Every other thing you listed is wasted ink.  I will repeat that:  you were not getting credit for your property taxes whether they were $5k or $50k a year. 

What will change in 2018?  The standard deduction will rise to $24k from $12k.  If you choose to take standard deduction your credit for kids, mortgage, property and charity go invisible.  You don’t deduct anything bexise you are CHOOSING to take the $24k.  Let thst sink in.  Everything you thought “well at least i get a deduction” you will not.  Including charity.  THERE ARE NO DEDUCTIONS IF YOU CHOOSE STANDARD DEDUCTION.   It is estimated that if the 30% of filers who choose to itemize in 2017;  2/3 of them will now choose the $24k standard.  This is ground swelling change in taxes and entirely different outlook on tax deductions. 

If yiu still want to itemize in 2018 the bad news is they are capping the sum of property taxes and state taxes at $10k.   This has high tax states up in arms.  But remember if you were AMT you weren’t getting deduction for it anyway.   2018 they are abolishing the AMT (theoretically).  So although my propety and income taxes is capped I’m doing better by the removal of that “implied” 26% amt bracket.  The new brackets for 2018 are wider and the nominal rates are lower.  Most come out ahead 

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Just for accuracy, the marginal tax rates and income brackets for 2017:

 $0 - $9525 bracket, you pay 10%. 
From $9525 - $38700, 15%. 
From $38700 - $93700, 25%. 
From $93700 - $195450, 28%. 
From $195450 - $424950, 33%. 
From $424950 - $426700, 35%. 
From $426700 and above, 39.6%. 

For 2018:

 $0 - $9525 bracket, you pay 10%. 
From $9525 - $38700, 12%. 
From $38700 - $82500, 22%. 
From $82500 - $157500, 24%. 
From $157500 - $200000, 32%. 
From $200000 - $500000, 35%. 

From $500000 and above, 37%. 

 

I just wish some of those brackets had been eliminated. 

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I think it is a more complicated.

For AMT you get a much larger deduction so many people don't have to pay it. I believe that the final law still has AMT just with an even larger deduction.

As your income went up you weren't getting all of those itemized deductions anyway (separate from AMT). They took away some of them as your income rose. The same is true for your exemptions. Your accountant or you had to fill out a bunch of worksheets to figure this out.

Capital gains makes it even more complicated.

I don't think we are getting to that 3x5 return that Trump spoke about anytime soon.

You can get a ballpark of how you would do under the new tax plan by using the Tax Plan Calculator at: http://taxplancalculator.com/ You just enter a few numbers from your 2016 return to find out. It also has a good relatively simple explanation of what is changing (well the AMT explanation is a little bit more complicated).

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Yes and yes to the above.  I just wanted to keep it simple so people stayed interested.   If people truly understand my part it will really get them aware.   

I feel it’s important to really know.   It all adds up to THIUSANDS of dollars a year. 

“I give $500 to goodwill and $500 to Red Cross but I get like 30% back in tax deduction”.    Oh no you won’t if you standard deduction.     “I moved to a new house.  My taxes are like $4k higher, but it’s not really $4k more because of the deduction”.    Probably not true anymore!

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2 minutes ago, Barms said:

“I give $500 to goodwill and $500 to Red Cross but I get like 30% back in tax deduction”.    Oh no you won’t if you standard deduction.

The unintended consequences of this may be that charities see a drop in donations which would not be a good thing.

I'm not sure that will happen as I wish to believe that most people give to charities not because of the tax deduction.

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You have “earned income”.   Most people get a paycheck.   We call those people “W2 earners”.   You get a gross wages number at end of the year.   That gross wage starts being applied to a thing called marginal tax brackets. You owe zero taxes on the first part of gross wages call it 0 to 19k.  Then from like 20k to 40k it’s like 10%. Then from 40 to 60k it’s like 22% and 5 more buckets all the way up to 39%.  You add up all those increments and that is how much officially the Fed wants from your gross wages.  That all in combo is your effective tax bracket.   Just for this primer lets say you have 100k in gross wages and your effective bracket worked out to 29%.   You earned 100 but only kept $71.   $29 goes to Uncle Sam  
but wait,  there are things you pay for in life that that you can apply to REDUCE your gross wages.  Call that “adjusting” your gross wages.   Have kids?  Reduce a couple of grand, have a mortgage? Reduce your gross wages by the amount of mortgage interest you pay.  Pay property taxes?  Reduce by that.  Pay state INCOME taxes?  Get more reduction for that from the Fed the line is called “taxes paid to other jurisdictions”.   Give to charity?  Reduce by that too.
So a lot of money laid out can “adjust” your income.  Let’s say the sum of the kids, mortgage; prop taxes, state taxes and charity is.   $11k.   So your wages are not $100k they are $89k.   Let’s assume same brackets as above 29% effective.  You owe $11k x 29% LESS in taxes owed becsuse of deductions.  $3 grand!
next, you look at that $11k adjustment and you say man life is good with these deductions,  but actually the Fed gives you an automatic minimum deduction if you choose.  It’s currently $12k.   So all those items you worked so hard tallying up to get to $11k is still not as beneficial as taking the STANDARD $12k
now, if the sum of your kids mortgage property local income and charity is say $25k then you pass on the standard and you submit an ITEMIZED deduction list that brings your $100k down to $75k.   Now let’s say that new smaller amount makes your effective bracket be 25%.   You earned $100k and keep $75k of it. 
What if you had 7 kids and your property taxes were $20k and your mortgage interest was $20k and you made $10k in charity payments.   Your adjusted wages is now $50k.   $50k in wages is only like the 22% effective rate.   So your gross wages is $100k your adjusted is 50k you only owe 22% on $50.   You earned $100 you keep Ike $88 of it.   So massive property taxes and state income taxes and 7 kids is great right?  Pay less taxes!   Not so fast.   The Fed does not let someone have massive deductions relative to their gross wages.  They ballpark by putting in a floor effective rate.  It’s about 26% effective rate.  So you THOUGHT you were gonna ow just 22% on 50k but the floor was 26% on the $100k.  They are making you calculate your taxes owed an ALTERNATIVE way.   You now owe $26k in taxes on your $100 not $12.
anytime that alternative is triggered it doesn’t matter a single solitary cent how many kids you have, what your property taxes are etc.  it doesn’t change your 26% floor whatsoever.  If you were AMT only two things adjusted your wages your mortgage interest and your charity.  Every other thing you listed is wasted ink.  I will repeat that:  you were not getting credit for your property taxes whether they were $5k or $50k a year. 
What will change in 2018?  The standard deduction will rise to $24k from $12k.  If you choose to take standard deduction your credit for kids, mortgage, property and charity go invisible.  You don’t deduct anything bexise you are CHOOSING to take the $24k.  Let thst sink in.  Everything you thought “well at least i get a deduction” you will not.  Including charity.  THERE ARE NO DEDUCTIONS IF YOU CHOOSE STANDARD DEDUCTION.   It is estimated that if the 30% of filers who choose to itemize in 2017;  2/3 of them will now choose the $24k standard.  This is ground swelling change in taxes and entirely different outlook on tax deductions. 
If yiu still want to itemize in 2018 the bad news is they are capping the sum of property taxes and state taxes at $10k.   This has high tax states up in arms.  But remember if you were AMT you weren’t getting deduction for it anyway.   2018 they are abolishing the AMT (theoretically).  So although my propety and income taxes is capped I’m doing better by the removal of that “implied” 26% amt bracket.  The new brackets for 2018 are wider and the nominal rates are lower.  Most come out ahead 


Very good analysis, however you should not be using the word adjustments as they are very different than deductions. Adjustments are specific above the line reductions in your income to come with what is known as adjust s gross income. Deductions are below the line r suction’s to come up with taxable income.

Also even for people that take a standard deduction there are also tax credits which are different than deductions. While deductions only give you a reduction in taxable income credits actually reduce your tax dollar for dollar. That assumes you actually owe tax, but there are som credits such as the child tax credit which are partially refundable.

Bottom line even though the changes make it simpler for many with a large standard deduction the tax code is still very complex. Oh and the new 24k standard deduction is not really double the old 12k one as they have taken away the $4050 personal exemption. So a married couple with no kids was getting $20,100 with those two combined and now gets $24,000 effectively. Even if they did not take the standard deduction they got to take the $4050 personal exemption. So many actually come out worse BUT it com a out in the wash with the bracket changes that are all about 2% points lower. Bottom line is even in the socialist people’s republic of New Jermany most will Pay lower Federal taxes, just not as much lower than if they lived in a fiscally responsible state.

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Nice explanation!  I sort of knew most of that, but I appreciate the review on the specifics of it.

For quite a few years now, I've been under the AMT, so whenever I hear about tax brackets and deductions, I mostly tune out, because it's all irrelevant to me.

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