I am an unmarried young person who has just started my first "real job," and accordingly have been diving deep into income taxes. Here is what I've learned -- I've tried to summarize things that would be important/applicable to an ordinary person, or at least an ordinary Boglehead who doesn't know much about taxes.
EDIT: If I've made any mistakes, or if you have other "basic" tax strategies, please reply! I did not include information about capital gains management (loss/gain harvesting), since I feel that is well covered on the forums.
The figures below show the marginal tax rates and average tax rates for an unmarried person, under 65 years of age, with no dependents, as a function of adjusted gross income (AGI). They were prepared after a quick review of the 2012 IRS form 1040 and a tax table for 2012.
As a reminder, AGI = W-2 wages + (other income) - (trad. IRA deduction) - (student loan interest deduction),
where (other income) consists, generally speaking, of interest earned; alimony received; non-qualified dividends; capital gains distributions; rent received; taxable social security benefits; IRA and pension distributions; unemployment compensation; etc. Note that traditional 401(k) contributions reduce W-2 wages.
The following assumptions and calculation methods were used:
a. The taxpayer is unmarried, younger than age 65, and not blind.
b. The taxpayer has no dependents and takes a standard deduction, so that
taxable income is AGI less standard deduction less one exemption amount.
c. The calculations do not consider any "phaseouts," since those would affect AGI directly.
In my mind, the biggest takeaway from these figures and is this:
It makes a big difference to keep AGI below $45,100, and therefore in the 15% tax bracket. There is a smaller marginal rate increase at $95,400, from 25% to 28%.
In addition, the average tax rate (taxes paid divided by gross income) for most individuals in the United States is between 5 and 20%, assuming that AGI is approximately equal to gross income for many Americans.
Finally, a person can minimize their taxes by reducing their AGI and their taxable income, as discussed below.
A. Given a certain amount of gross income, minimizing AGI can save some serious money, especially in upper tax brackets. For a person who is not self employed, the way to do this is to reduce W-2 income, or increase the deductions on Form 1040.
- a. Contribute to a traditional 401(k), 403(b), TSP, or similar plan. Up to $17,000.
b. Contribute to a traditional IRA. Up to $5000.
c. Use a Flexible Spending Account (FSA) for healthcare expenses or childcare. Up to $2,500 for medical expenses, $5,000 for dependent care.
e. Use a Health Savings Account if you have a high-deductible healthcare plan. Up to $3100.
f. Use a pre-tax spending account for commuting expenses (requires employer cooperation). Up to $1500.
B. Along with minimizing AGI, it's desireable to reduce taxable income as far as possible with itemized deductions, if the sum of these exceeds the standard deduction ($5950 for a single person). These include:
- i. Unreimbursed medical and dental expenses, in excess of 7.5% of AGI.
ii. Interest paid on home mortgages and investments.
iii. Taxes paid to state and local governments.
iii. Charitable gifts.
iv. Work-related expenses in excess of 2% of AGI.
I. Focused income range