Where Our Taxes Go

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The photo above is from an article that breaks down how the government uses our tax dollars.  Take a look if you’re interested in knowing more about where your taxes go.


Using Money in Your Roth IRA

The rules for using money in your Roth IRA share a lot of similarities to the rules and exceptions for using money in your Traditional IRASee here for the full list of when you can use your Roth IRA without paying a 10% penalty.  One difference, however, is that your Roth IRA has to be opened for at least 5 years before you start taking money out.  Even if you meet one of the other requirements (like reaching age 59.5), if your Roth IRA hasn’t been opened for at least 5 years, you will still be subject to the 10% penalty.

However, there are 2 advantages to taking money out of a Roth IRA vs. a Traditional IRA:

  1. When you take money out and it’s a qualified distribution, you don’t have to pay any tax because you already paid tax when you put money into the account.
  2. Even when it’s a non-qualified distribution, you don’t have to pay the 10% penalty on your contributions.  You just have to pay the penalty on the interest earned in the account.  Here is an example I gave my friend:
    • Let’s say you put in $5,000 into your Roth IRA 7 years ago and your account grew to $8,000 because of your investment returns.  You can take out $5,000 anytime without paying tax or penalty because that is your contribution amount.  But if you take out $8,000, you have to pay a penalty (and tax!) on the $3,000 worth of earnings.

Using Money in Your Traditional IRA

Most people know that IRAs are used for retirement.  But what is considered “retirement” and what happens if you use the money before then?  The rules are a little different for Traditional IRAs and Roth IRAs so today I will only cover Traditional IRAs for the sake of brevity.

“Retirement” for IRA purposes is age 59.5.  Once you reach age 59.5, you can start taking money out of your IRA without penalty.  But don’t forget, you’ll still have to pay taxes on whatever amount you take out because Traditional IRAs are typically funded with pre-tax money (income you have not paid taxes on yet).  If you take money out of your IRA before age 59.5, you will have to pay a 10% penalty on the amount you take out (in addition to paying taxes).

Luckily, there are a few exceptions to this rule.  If you are not age 59.5 but use your Traditional IRA for things like:

  • unreimbursed medical expenses that are more than 10% of your adjusted gross income,
  • medical insurance when you’re unemployed,
  • when you are totally and permanently disabled,
  • qualified higher education expenses (i.e. grad school),
  • to buy, build, or rebuild a first home,

you will not have to pay the 10% penalty.  This is great news for those of us who are worried about not being able to use our IRAs anytime before we retire, which if you’re a millennial, probably won’t be for a long time.


Alternative Minimum Tax

The Alternative Minimum Tax was created by Congress to prevent people from using loopholes to avoid paying taxes.  The way your AMT is calculated is similar to the way your regular tax is calculated except a lot of the deductions that you were able to take for regular tax are no longer allowed.  If your AMT turns out to be higher than your regular tax, you will have to include the difference on Line 45 of your 1040.

Most of us millennials will not have to worry about paying AMT unless we’ve reduced our taxes by taking a lot of itemized deductions (mainly in real estate or property taxes).  But the only way to know whether you have to pay AMT or not for sure is to fill out Form 6251.


Taxable Income & Tax Rate Schedule

After you figure out what’s included in your Gross Income (Line 22 of your 1040),

and then subtract certain expenses to get your Adjusted Gross Income (Line 37),

and then subtract your Standard or Itemized Deductions from your AGI (Line 41),

you subtract from Line 41 your exemptions (Line 42) to get to your Taxable Income (Line 43).  Your Taxable Income is used with the Tax Rate Schedule to figure out how much Tax you need to pay that year (Line 44).  See below for a calculation example.

Here is the 2013 Tax Rate Schedule for someone filing Single on their tax return:

If taxable income is over—
but not over—
the tax is:
$0
$8,925
10% of the amount over $0
$8,926
$36,250
$892.50 plus 15% of the amount over $8,925
$36,251
$87,850
$4,991.25 plus 25% of the amount over $36,250
$87,851
$183,250
$17,891.25 plus 28% of the amount over $87,850
$183,251
$398,350
$44,603.25 plus 33% of the amount over $183,250
$398,351
$400,000
$115,586.25 plus 35% of the amount over $398,350
$400,001
no limit
$116,163.75 plus 39.6% of the amount over $400,000

Pretend your Taxable Income (Line 43 of your 1040) is $50,000.  Your marginal tax rate is 25% because your Taxable Income is between $36,251 - $87,850.

To calculate how much Tax you need to pay, take $4,991.25 + [25% x ($50,000 - $36,250)] = $8,428.75 (this amount will be reported on Line 44).

I suggest testing this calculation out yourself using your 2012 Tax Return.  See if you can get to the same number that was reported on Line 44 of your 2012 1040.  Just don’t forget to use the 2012 Tax Rate Schedule and not the 2013 one.


Standard Deduction vs. Itemized Deductions

If you look on the second page of your 1040, you’ll see on the top left-hand side a box that says “Standard Deduction.”  If you’re single (aka not married), your standard deduction is $6,100 for 2013.  What is a deduction?  It’s basically just another item that reduces the amount of income you have to pay taxes on.  It’s taken after you calculate your Adjusted Gross Income (Line 37/38).  You can take either the standard deduction or an itemized deduction on your tax return, but not both.

Most of us will be taking the standard deduction because the total of our itemized deductions won’t be greater (i.e. won’t be above $6,100 if you’re single in 2013).  Since deductions reduce your taxes, you always want to take the deduction that has the largest amount between the two.

Itemized deductions are also known as Schedule A and “deductions FROM AGI”.  Here are some examples of itemized deductions:

*A lot of people donate to church or a charity thinking it will reduce their taxes.  Unfortunately, unless your donation plus anything else on the itemized list is more than the standard deduction, you won’t receive any tax benefit from that donation.  You should still donate, of course.  I just want to clarify the popular misconception.


Adjusted Gross Income

To get our Adjusted Gross Income (Line 37 of our 1040), we get to subtract certain expenses from our Gross Income (Line 22 of our 1040).  The expenses we get to deduct is often referred to as items “deducted FOR AGI” or “ABOVE the line deductions”.

Here is what you can subtract (I suggest looking at a 1040 as you read this list!  The items in green are more common to us millennials.):

You add all those items up and put the total on Line 36 and then subtract Line 36 from Line 22 (your Gross Income).  The difference goes on Line 37, which is your AGI.

Your AGI is used for a number of tax calculations.  So the lower your AGI, the better.


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