Getting FIT: Learn How Federal Income Tax is Calculated

February 21, 2019

How are taxes calculated? Learn how Federal Income Tax is calculated with the tax tables and salary amounts to understand your taxes like a pro!

calculation explosion!

How are Taxes Calculated?

To continue on the tax track from last week’s blog, we’re taking a step back from W-2’s to see how those tax amounts got on there in the first place! Understanding your W-2 is important, but it’s equally important to understand tax tables!

Before I started selling payroll many moons ago, I didn’t get it. By “it,” I mean that I didn’t understand FIT.  FIT is an acronym for Federal Income Tax. It’s also known as the tax that takes the largest bite from your paycheck.

Working for a payroll company taught me that reading and understanding my pay stub is extremely important.  FIT was the first thing I learned when I began decoding pay stubs. Even today, I pay close attention to legislature and how politics affect my take-home pay.

You might wonder why the government gets to eat such a sizable piece of your hard-earned money.  Well, after collecting FIT from all of us, the government uses the funds to support many public agencies and programs.  Without your contributions each year, programs such as Medicaid, veterans’ benefits, and water management (those are just a few on a long list) would not exist. Or at least those programs would not survive without private funding.

Of course, how they spend our contributions are always up for debate.  People can’t seem to agree on the best use of funds, and many are passionate about their own philosophies. Nevertheless, the tax is here to stay! So we all are better off accepting it and learning how to appreciate its purpose, all the while still learning how it applies to each of us.

As part of this process, we need to learn how taxes are calculated.  Are you under the impression that FIT is Merely a percentage of your salary?  Well, the answers are yes and no, but mostly no.  Let’s take a look!

Tiering up

As you’re making money each year, your earnings fall into tiers or brackets.  The tax brackets are based on salary ranges. You then take a percentage of that salary range. After your salary exceeds a bracket, the next chunk of your salary applies to the following tier.  So you have a clearer picture, the tax brackets for wages earned in 2018 are below:

2018 Federal Income Tax Tables
2018 Federal Income Tax Tables

The IRS releases new tax brackets every year, Publication 15 or Circular E. While we’ll warn you now it’s not the most thrilling publication, it will help you further understand how taxes are calculated!

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The Circular E is always available online – here is 2019’s downloadable PDF. To find the tax table like the one above, navigate to the “Federal Income Tax Withholding Methods” section beginning on page 46.

Real-life scenarios of How Taxes are Calculated

Let’s pretend we’re calculating an average Joe’s taxes, we’ll call him Juan Maestro.  Juan is a young public school teacher, and his salary is $45,000 per year.  According to the table outlined above, this is how Juan’s taxes are calculated:

  1. $9,525 of his income is taxed at 10%, which is $953 (rounding up).
  2. From the $9,526 to $38,700 range, Juan is taxed at 12%.  The difference between these two figures is $29,174. Multiply this amount by 12%, which comes out to $3,501.
  3. From $38,701 to $45,000, Juan is taxed at 22%.  The difference between these two figures is $6,299, and the final amount is multiplied by 22%, which comes out to $1,386.

If you add up those three amounts, Juan’s total tax liability is $5,840. This equates to his effective tax rate of 13%, even though his marginal tax rate (the rate in his highest tax bracket) is 22%.

Clear as chocolate pudding?  Yummy!

Pre-tax me, please!

One thing to remember – since Juan works for the public school system, he likely receives great benefits, including pre-tax health options and an FSA (Flexible Spending Account).

Let’s pretend Juan opted into both the employee-sponsored health insurance and the FSA.  If the health insurance premium is $200 per pay period and Juan contributes $10 per pay period ($260 for the year), his taxable income will be $210 per pay period less than what it would be if he wasn’t opting into these pre-tax benefits. 

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For example, let’s say Juan’s gross paycheck is $1,730.77 and he’s opting into the pre-tax health insurance and contributes pre-tax dollars to an FSA account. Using the first tier of the tax brackets, if Juan’s gross paycheck is $1,730.77, his taxable income for that paycheck wouldn’t be the full $1,730.77—it would be $210 less.  So, that means his taxable income would be $1,520.77.

Let’s take a side-by-side look at how this changes Juan’s taxable income:

Example of taxable income with and without pre-tax deductions

Did you notice that Juan’s FIT taxes without pre-tax deductions are $21 higher on this paycheck alone?  That’s not counting any additional pre-tax deductions you might have!  It’s also not taking into consideration any other taxes (SIT, FICA) that would decrease from pre-tax deductions. 

So, the moral of this story is if you want Uncle Sam to take a smaller bite out of your paycheck, opt into any pre-tax deductions made available to you.

Dollars on your check means dinner on the table

At the end of the day, we all need to “get FIT.”  Understanding FIT helps us learn what we can do to keep more of our hard-earned money.  Think of your paycheck this way:  misunderstanding taxes and how they’re calculated ultimately means the pie on your table will either be yours or Uncle Sam’s.  Who would you rather get the bigger piece of the pie?  Knowing your taxes will help you decide who it will be.

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