Better Understand Income Taxes

Better Understand Income Taxes

Better Understand Income Taxes

With tax season coming to a close, we wanted to give you a head start on tax insights for next year. Sure, we plan and prepare your taxes but, in our latest FPFoCo Academy module, we make the whole process less mysterious and easier for you to wrap your head around. 

In this module preview, we’ll take a closer look at adjustments, deductions, and credits. Here’s a little U.S. tax history to get us started. 

U.S. Tax History

Before the 16th amendment was passed, the United States introduced its first income tax in 1861 as a means (among many) to pay for the needs of the Civil War. At the time, income tax rates were low (3%-5%) and apportioned between the states based on the 1860 census. This meant that residents of New York, the most populous U.S. state in 1860, would pay a different federal income tax than residents of Oregon, the least populous in 1860. This early income tax was repealed in 1872, and the apportionment requirements of the Constitution made it impractical to levy a new peacetime income tax. With the ratification of the 16th amendment in 1913, the need for apportionment was eliminated and the modern income tax was born.

In the century and more that followed, the federal income tax has really served two purposes:

1. To raise revenue for the United States Treasury
2. To shape and encourage certain behaviors of taxpayers

While the first purpose is obvious, the second may be less so. The use of the tax system itself to shape the behavior of taxpayers has existed since the 1913 Income Tax Act. For example, within the act was a provision to tax dividend income differently from earned income, therefore creating a preference for capital investment and the income it created. As it had been primarily a tax on the rich before, in 1944, when the middle class first became exposed to paying income taxes, Congress allowed for the first standard deduction — a 10% reduction in income — which reduced the record-keeping burden but more importantly encouraged compliance with an already overly complex system.

Current Incentives Baked Into the Code

Today, you’ll notice and have easy access to these rewards within the tax system.

Incentives exist for saving and investing, generally for the long term.

Saving for retirement is encouraged by the availability of numerous deductions and preferences for adding money to accounts like 401(k)s or IRAs.

The same is true for saving for health care expenses and the use of the HSA (and other health-saving-related accounts).

You can gain tax-free interest on municipal bonds to invest in your local community and/or other areas of need. The interest from these bonds is typically exempt from federal, state, and local taxes.

The U.S. government continues to encourage investing capital for the long term through lower tax rates on dividends and the gains realized when selling capital investments for cash.

A tax credit — a dollar-for-dollar offset of tax due — provides even more incentive to do what you may not do otherwise. Think about credits for:

Installing solar panels or devices for other renewable energy production.

Buying a plug-in electric vehicle.

Raising upcoming members of society who’ll make future taxable income for the government: The child tax credit provides a credit up to $2,000 per child under age 17 (up to $3,600 for children under 6, and $3,000 for children 6 and older in 2021).

Elected politicians added all of these incentives. Congress can enact, remove, and edit parts of the U.S. tax code. All of this political debate will influence what you ultimately owe in income taxes.

What Happens Between Gross Income and Your Total Tax?

The short answer: a whole lot! This is where the complexities of the U.S. tax code come into play. Whenever you hear politicians debating the tax code, they are either adding more complexity, removing complexity, or updating existing complexity.

Instead of diving into each and every section of the tax code, we’re going to define some terms relevant to these areas of the tax code.

Income Tax Calculation

– Adjustments (aka above the line)

These adjustments are important because the more you can claim, the lower your Adjusted Gross Income (AGI). Since many calculations consider your AGI as the basis for determining everything from ACA premium tax credit to the ability to make a Roth IRA contribution, it’s an extremely important detail on your tax return. Some of the adjustments/deductions include:

Educator expenses

Health savings account contributions.

Self-employment costs (retirement plan contributions, insurance premiums, and half of the self-employment tax reported on Schedule E)

Student loan interest

Tuition and fees educational expenses

Traditional IRA deduction

Nickname Origin: In 2017 and earlier, these deductions appeared on the first page of the tax return. That’s why they are nicknamed “above-the-line” deductions.

= Adjusted Gross Income (aka AGI, aka “the line”)

People were motivated in 2020 to identify their Adjusted Gross Income. This taxable definition became relevant with the Economic Impact Payments (EIP) intended to combat the economic impact of the COVID-19 pandemic in the United States. In order to qualify for an EIP, aka stimulus payment, your household AGI had to be below a certain level.

That’s a theme with AGI. AGI is important to measure and gauge many phaseouts, eligibility for certain credits, and, in some states, it factors into your state income taxes. 

– Deductions

The difference between deductions and credits can get confusing, but there’s an easy way to differentiate. Deductions reduce the amount of income that is subject to federal income tax. Credits reduce the amount of your federal income tax on a dollar-for-dollar basis. Going back to the calculation, subtract your deductions from your AGI to determine your taxable income. You either have a simple approach and take a standard deduction, or you can itemize your deductions. 

The two ways to calculate your deduction fall into an either-or scenario, so you can’t combine them. While it is nearly always more advantageous to take the larger of the two deductions (standard or itemized) you are generally always permitted to take whichever you’d like. If you are married and you file separately, you and your spouse must either both itemize your deductions or both take the standard deduction.

▶︎ The Standard Deduction

Even if you have no qualifying deductions, the tax code allows you to take the standard deduction to decrease your taxable income. These flat-dollar amounts are listed in the chart below.

Standard Deduction Amounts

▶︎ Itemizing Your Deductions

The sum of your itemized deductions) isn’t a straightforward calculation. Some expenses are limited to a percentage of your AGI. Yet it’s still worthwhile for us to calculate your potential itemized deductions. Some examples of itemized deductions include:

Unreimbursed medical and dental expenses: the amount that exceeds 7.5% of your AGI

Long-term care premiums: as medical expenses, limited based on your age

State and local taxes: limited to first $10,000

Mortgage interest: generally on the first $750,000 of a loan used to buy, build, or improve your main or second home

Charitable donations: typically up to 60% of your AGI when donating to “public” charities but can be up to 100% in 2021

Pro Tip: When do you want to itemize your deductions? Whenever the amount is greater than the standard deduction. It’s good practice to calculate your potential itemized deductions every year to ensure you’re taking the most beneficial deduction possible. Again, this is where we’ll help you determine which deduction makes sense for you.

= Taxable Income

This is the amount that will be relevant when calculating the tax owed. This is where we’ll consider the factors we shared in a previous section.

Your filing status and your marginal tax brackets

Remember, you can’t just take your taxable income and multiple it by X% to find out your tentative tax. You have the marginal tax brackets as well as the Schedule D worksheet — if you have capital gains or qualified dividends — to consider. The long and short of it is that there is not a one-size-fits-all calculation for your tentative tax. In fact, even the same taxpayer may use a different tax calculation each tax year. Once we calculate the marginal tax brackets to your taxable income, we’ll identify your tentative tax due.

= Tentative Tax

This is the amount of tax you owe before the next steps in the calculation.

+ Additional Taxes

Things get complicated again. At this step, various additional taxes may be added, depending on the taxpayer’s very specific situation. These most common additional taxes include:

Alternative Minimum Tax: A parallel tax system enacted in the 1960s to ensure that taxpayers don’t use certain types of incomes and deductions to eliminate all of their tax liability. The AMT applies to everyone, but very few taxpayers actually pay AMT.

Additional Medicare Tax: Applies to taxpayers with earned income (wages and earnings from self employment) exceeding certain amounts.

Net Investment Income Tax: Applies to taxpayers with investment income and AGI exceeding certain amounts.

Self-Employment Tax: Applies to taxpayers filing Schedule C and F with net profit from self-employment or farming. This is a replacement for the employER and employEE portions of Medicare and Social Security payroll taxes.

– Credits

While deductions lower your taxable income, credits are a dollar-for-dollar reduction of tax. In some cases, credits may even be refundable, meaning that you receive them even if you’re refunded an amount greater than what you’ve paid in.

Tax Deduction vs Tax Credit

How do credits work? Say in 2021 you have a 9-year-old child and you meet the qualifications for the child tax credit of $3,000 per child age six and older. If your tentative tax is $6,000, you can subtract the $3,000 credit, resulting in a total tax of $3,000. 

Some examples of credits available to individuals who meet the rules and qualifications:

  • Child tax credit
  • Credit for other dependents
  • Child and dependent care credit
  • Earned Income Tax Credit (ETIC)
  • Retirement Contribution Savings Credit (Saver’s Credit)
  • American Opportunity Tax Credit (AOTC)
  • Lifetime Learning Credit (LLC)
  • Federal Adoption Tax Credit
  • Foreign Tax Credit
  • Residential Energy Efficient Property Credit
  • Plug-In Electric-Drive Motor Vehicle Credit

As you can see, many of these credits reward taxpayers for certain behaviors.

= Total Tax

Looking for more ways to understand taxes? Log into FPFoCo Academy! There, you can find the entire Better Understand Taxes module — or take a deep dive into any one of our other courses, like Tax-Favored Savings and Investments or Year-End Tax Planning

Taxes not your thing? (That’s what we’re here for!) With more than 25 modules available, you might just find something that interests you. Don’t see a personal finance course that tickles your fancy? Let us know what you’d like to see, and you just might find it next month in FoCo Academy!

If you have questions, try the chat feature at the lower-left corner of this page.

Ready to schedule your next meeting? Simply head to the Meeting page where you can find and schedule a convenient time to discuss whatever is on your mind.

Dan Andrews
dan@fpfoco.com

Dan Andrews is a CERTIFIED FINANCIAL PLANNER™ professional and the Director of Estate and Financial Planning at Financial Planning Fort Collins. With unique experience working with members of generations X and Y, he has served clients of all ages and backgrounds since 2012. Dan enjoys a light-hearted approach toward Financial Planning to make the process more fun for clients. He enjoys giving back to the profession and the community. Dan has served as the Vice President of the XY Planning Network Diversity Committee and as the Public Relations Director for the Financial Planning Association of Colorado. To learn more, read Dan's blogs or the articles he’s been featured in.



MINIMUM ACCOUNT SIZE
The minimum initial investment for the Invest:FOCO platform is only $5,000 per account. This minimum can be met via transfer of an existing account or with new funds.
ANNUAL FEE
1.00% of assets under management ($100 per $10,000 managed). Debited from your account(s).
FINANCIAL PLANNING
Strategy:FOCO financial planning services are ongoing, and include unlimited phone, email, web and in-person meeting and consultation time. Pricing is based on the unique circumstances of each client situation. Generally, there is a one-time plan development fee ranging from $500 - $2,000 and a monthly fee of $150 - $500; cancel anytime. Clients utilizing investment management services with portfolios of $500,000 or more will typically receive financial planning services for no additional fee.
INVESTMENT MANAGEMENT
Assets Under Management (AUM)Annual fee as a % of AUM or flat-dollar
$0 - $249,999(See Invest:FOCO)
$250,000 - $499,9990.90%
$500,000 - $999,9990.80%
$1,000,000 - $1,999,9990.65%
$2,000,000 - $2,999,9990.50%
$3,000,000 - $3,999,999$15,000
$4,000,000 - $4,999,999$20,000
$5,000,000 or more$25,000 + $2,000 per additional $1mm
MINIMUM ACCOUNT SIZE
There is a minimum initial investment of $100,000 per Strategy:FOCO client household. This minimum can be met via transfer of existing accounts or with new funds. A client household may generally include accounts for a head of household, a significant other, dependents, and any controlled organizations or entities.

Minimums do not apply to inStream proactive financial planning as a stand-alone service.
ANNUAL FEE
Assets Under ManagementFee as a % of AUM
$100,000 - $249,9991.00%
$250,000 - $499,9990.90%
$500,000 - $999,9990.80%
$1,000,000 - $1,999,9990.65%
$2,000,000 or more0.50%

inStream proactive financial planning as a stand-alone service: $1,000/year or $100/month
MINIMUM ACCOUNT SIZE
There is a minimum initial investment of $100,000 per Strategy:FOCO client household. This minimum can be met via transfer of existing accounts or with new funds. A client household may generally include accounts for a head of household, a significant other, dependents, and any controlled organizations or entities.

Minimums do not apply to inStream proactive financial planning as a stand-alone service.
ANNUAL FEE
Assets Under ManagementFee as a % of AUM
$100,000 - $249,9991.00%
$250,000 - $499,9990.90%
$500,000 - $999,9990.80%
$1,000,000 - $1,999,9990.65%
$2,000,000 or more0.50%

inStream proactive financial planning as a stand-alone service: $1,000/year or $100/month
MINIMUM ACCOUNT SIZE
The minimum initial investment for the Invest:FOCO platform is only $5,000 per account. This minimum can be met via transfer of an existing account or with new funds. Invest:FOCO is currently available for Individual, Joint, Traditional IRA, and Roth IRA registrations.
ANNUAL FEE
0.65% of assets under management ($65 per $10,000 managed)
MINIMUM ACCOUNT SIZE
The minimum initial investment for the Invest:FOCO platform is only $5,000 per account. This minimum can be met via transfer of an existing account or with new funds.
ANNUAL FEE
0.65% of assets under management ($65 per $10,000 managed)
TAX PREPARATION
Invest:FOCO clients are eligible for a 10% discount on income tax preparation services offered through Fort Collins Tax Service, LLC. This discount applies to the base cost for return preparation as well as Schedules B & D. More details can be found here.
MINIMUM RELATIONSHIP SIZE
There are no minimums when utilizing inStream proactive financial planning as a stand-alone service.

When investment management services are desired, there is a minimum initial investment of $125,000 per Strategy:FOCO client household. This minimum can be met via transfer of existing accounts or with new funds. A client household may generally include accounts for a head of household, a significant other, dependents, and any controlled organizations or entities. inStream proactive financial planning is then included at no additional cost.
ANNUAL FEE
inStream proactive financial planning as a stand-alone service: $1,250/year or $125/month

Assets Under ManagementFee as a % of AUM
$125,000 - $249,9991.00%
$250,000 - $499,9990.90%
$500,000 - $999,9990.80%
$1,000,000 - $1,999,9990.65%
$2,000,000 or more0.50%
TAX PREPARATION
Strategy:FOCO clients are eligible for a 50% or 100% discount on income tax preparation services offered through Fort Collins Tax Service, LLC. This discount applies to the base cost for return preparation as well as Schedules B & D. More details can be found here.
Monthly Economic Update
Stay in the loop with our Monthly Economic Update. It's a great way to catch up on the things effecting your financial plan in an easy to read and relatable format.

We promise to only use your name and email address for sending our Monthly Economic Update. We will not sell, rent, lease, loan, or use your name or email address for any other purpose, internally or externally. You can easily unsubscribe at any time.
Monthly Economic Update
Stay in the loop with our Monthly Economic Update. It's a great way to catch up on the things effecting your financial plan in an easy to read and relatable format.

We promise to only use your name and email address for sending our Monthly Economic Update. We will not sell, rent, lease, loan, or use your name or email address for any other purpose, internally or externally. You can easily unsubscribe at any time.
MINIMUM ACCOUNT SIZE
Minimums do not apply to always-on, real-time financial planning as a stand-alone service.

For investment management services there is a minimum initial investment of $125,000 per Strategy:FOCO client household. This minimum can be met via transfer of existing accounts or with new funds. Investment management fees are generally debited from the accounts to which they apply. Financial planning services are included for Strategy:FOCO investment management clients at no additional charge.
ANNUAL FEE
Always-on, real-time financial planning as a stand-alone service:  $125/month or $1,250/year

Assets Under ManagementFee as a % of AUM
$125,000 - $249,9991.00%
$250,000 - $499,9990.90%
$500,000 - $999,9990.80%
$1,000,000 - $1,999,9990.65%
$2,000,000 or more0.50%
Five Savings Secrets
Are you 30 - 60? Let us give you a few tips with our free white-paper: Five Savings Secrets. Then stay in the loop with periodic emails featuring relevant information on financial planning, investment management, and income taxes.

We promise to never sell, rent, lease, loan, or use your email address for any other purpose, internally or externally. You can easily unsubscribe at any time.
Notice

This website or its third-party tools use cookies, which are necessary to its functioning and required to achieve the purposes illustrated in the privacy policy. If you want to know more or withdraw your consent to all or some of the cookies, please refer to the privacy policy.

By closing this banner, scrolling this page, clicking a link or continuing to browse otherwise, you agree to the use of cookies.

FINANCIAL PLANNING
Financial planning services are ongoing, and include unlimited phone, email, web and in-person meeting and consultation time. Pricing is based on the unique circumstances of each client situation. Generally, there is a one-time plan development fee ranging from $500 - $2,000 and a monthly fee of $150 - $500; cancel anytime. Clients utilizing investment management services with portfolios of $500,000 or more will typically receive financial planning services for no additional fee.
INVESTMENT MANAGEMENT
Assets Under Management (AUM)Annual fee as % of AUM or flat-dollar
$0 - $249,9991.00%
$250,000 - $499,9990.90%
$500,000 - $999,9990.80%
$1,000,000 - $1,999,9990.65%
$2,000,000 - $2,999,9990.50%
$3,000,000 - $3,999,999$15,000
$4,000,000 - $4,999,999$20,000
$5,000,000 or more$25,000 + $2,000 per additional $1mm
ESTIMATE YOUR FEE
Your fee is determined by the complexity of your needs and situation. The primary proxy we use for complexity is your investable net worth, which is generally your total net worth, excluding your primary residence. Your investable net worth includes the value of cash, bonds, stocks, mutual funds, rental real estate, and other business or financial interests. This aligns with the holistic nature of our comprehensive services. You can use the chart below to estimate your fee based on your investable net worth. In some circumstances, your fee may be more than the minimums in the chart below.
Minimum Annual Fee Investable Net Worth (INW)
$4,000Up to $500,000
$6,000Up to $1,000,000
$8,000Up to $1,500,000
$10,000Up to $2,000,000
$11,000Up to $2,500,000
$12,000Up to $3,000,000
+ $1,000per additional $1,000,000 of INW
Critical Money Tips
Need some tips to help you tackle your next critical money moment? Stay in the loop with our weekly(ish) email!

We promise to never sell, rent, lease, loan, or otherwise use your email address for any reason inconsistent with our privacy policy. You can easily unsubscribe at any time.
Critical Money Tips
Need some tips to help you tackle your next critical money moment? Stay in the loop with our weekly(ish) email!

We promise to never sell, rent, lease, loan, or otherwise use your email address for any reason inconsistent with our privacy policy. You can easily unsubscribe at any time.
Critical Money Tips
Need some tips to help you tackle your next critical money moment? Stay in the loop with our weekly(ish) email!

We promise to never sell, rent, lease, loan, or otherwise use your email address for any reason inconsistent with our privacy policy. You can easily unsubscribe at any time.
Critical Money Tips
Need some tips to help you tackle your next critical money moment? Stay in the loop with our weekly(ish) email!

We promise to never sell, rent, lease, loan, or otherwise use your email address for any reason inconsistent with our privacy policy. You can easily unsubscribe at any time.
Critical Money Tips
Do you have a cash surplus? Learn more what to do with extra money in the free-preview of our Teachable course: Sudden Money and Windfalls.

We promise to never sell, rent, lease, loan, or otherwise use your email address for any reason inconsistent with our privacy policy. You can easily unsubscribe at any time.
Critical Money Tips
Are you here because of a big change in your finances? Subscribe for our PDF on 6 questions to learn the benefits of working with a full-time fiduciary.

We promise to never sell, rent, lease, loan, or otherwise use your email address for any reason inconsistent with our privacy policy. You can easily unsubscribe at any time.
Inheriting Money Can Be Overwhelming.
We have the expertise to be your guide as you navigate receiving a windfall.
Equity Compensation Can Be Confusing.
Let us make it less complicated for you. Whether it’s a one-time award or ongoing compensation, we know how to help.