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How do taxes work in the first year?
Taxes are confusing. But they don't have to be! Read this post to learn about what taxes you'll pay in the first year of your career!
Disclaimer: I am not a CPA. This post only serves to provide an introduction to how U.S. tax rules work with personal income. Any recommendations provided within this article represent only my own opinions. I am not affiliated with any of the websites or products I discuss in this post.
One of the first questions my new grad mentees ask me after they sign an offer at a tech company is how much money they will actually see in their bank account after the first year. This is dependent on multiple income factors, including base salary, sign on bonus, and RSUs, as I describe in this post. But a factor I haven't discussed yet which has a huge impact on what you get to take home is taxes. And the tax rules are different for standard ordinary income (cash, bonuses) vs. RSUs (or even options). It's important to understand how to calculate your own taxes for a few reasons:
You can estimate how much you will actually make in a year and what your expected tax refund could be the following year (or if you will actually owe taxes).
You can double check the work of a CPA or confirm what a tax prep software solution like TurboTax (or something similar) calculates.
Taxes are a bit overwhelming initially, but with some baby steps, you can become a tax master. In this post, we'll consider only cash-based compensation (as would be the case with most new grads in their first year). With RSUs, things get a little more complicated and with options, they get even more complicated than that, but both of them change what is called Adjusted Gross Income (AGI), which is described in this post. So if you understand all the fundamentals in this post, then tacking on RSUs or options into your tax situation is just an incremental step.
Quick note: This post is just an introduction. For more complicated tax situations, I recommend following up with a CPA. I have found from personal experience that TurboTax Premier was perfectly capable of calculating my taxes, even with RSUs and capital gains and dividends from personal investments from my personal brokerage account, but in your case you can always have a CPA prepare your taxes if you're more comfortable with that.
Baby step 1: A timeline of income in the first year
Let's start by simplifying your income situation a bit and imagine that you've just started a new role in August (like most new grads do) and all your income is coming from cash, in the form of your salary and sign on bonus.
To supply some concrete numbers, let's say sign on bonus is $30k and salary is $135k. A possible timeline of actions taken and income made could be the following:
Baby Step 2: Calculating Taxable Income
Now that we've gone though a timeline, let's simulate calculating taxes. If your salary is $135k, and you worked starting from August in your first year, then you would have 5 months worth of pay from salary. Total gross income would look like:
5*($135,000/12) = $56,250 from salary
$30,000 from sign on bonus (remember that what was actually deposited in your account was 0.6*30,000 = $18,000, but we have to count the total bonus amount in gross income)
Total income = $56,250 + $30,000 = $86,250
This Total income value is called your Gross pay. But, this is not what you're actually taxed on. We still have to account for 401(k) contributions and the standard deduction. What I'm about to describe is only for Traditional 401(k), not Roth 401(k).
The maximum 401(k) contribution is $19,500, as of the writing of this post in 2021. For this example, let's say that you maxed out your 401(k) contributions and you hit that limit.
We need to subtract your 401(k) contributions from Gross pay to calculate the Reported W-2 Wages, or Wages, tips, other comp. This is the value that will be in Box 1 of your W-2:
Wages, tips, other comp: $86,250 - $19,500 = $66,750
Note: You can technically have other income, such as investment income, called additional taxable income that would be added to Box 1 to yield what's called Adjusted Gross Income (AGI). For now, we are going to assume there isn't other taxable income, so your AGI is what's in Box 1.
Now we have to calculate your taxable income, by accounting for either what's called the standard deduction (which is again, dependent on filing status) or itemized deductions. I'm not going to delve into the details of itemized deductions, but the basic idea is that there are classes of expenses you can use to deduct (or subtract) from your AGI to lower taxable income so you pay less in taxes. In contrast to itemized deductions, the standard deduction is an absolute dollar amount that can be deducted from your AGI. This ability to deduct a certain amount from your AGI is a benefit the federal government provides to lower your taxable income. And the best part is you have a choice between using either itemized deductions or the standard deduction to maximize the total deductions you can make.
Tax prep software like TurboTax will ask you a bunch of questions to determine if there are itemized deductions you can take. This allows it to calculate your total possible itemized deductions and compare that to just taking the standard deduction.
The value we can deduct from AGI in order to derive taxable income is:
MAX(standard deduction, itemized deductions)
Let's say your itemized deductions are not as much as the standard deduction. Therefore, we'll take the standard deduction of $12,550 (2021 single filing status standard deduction value).
= $66,750 - $12,550 =
Baby Step 3: Calculating Federal Income Tax
Now that we have your taxable income, we have to calculate how much you owe in federal income taxes, Social Security taxes, Medicare taxes, and state income taxes. Both federal income taxes and state income taxes are bracketed, meaning you are taxed at increasing rates on ranges of income. Social Security Taxes and Medicare taxes work a little bit differently.
Let's tackle federal income taxes first. If you go to a website like Nerdwallet or Bankrate, you can see all the federal income tax brackets. For now, I am only going to consider Single filing status, 2021 federal tax brackets:
As you can see, the brackets don't all have the same width. We have to use these ranges to calculate how much federal income tax we owe. The calculation works like so:
0.1*9,875 + 0.12(40,125 - 9,875) + 0.22*(54,200 - 40,125) =
Baby Step 4: Calculating FICA Taxes
FICA stands for Federal Insurance Contributions Act, which is a law that requires employees to have a portion of their paycheck taken out to fund Social Security and Medicare. Technically, even your employer has to make contributions to these programs. But, for our purposes, when we refer to "FICA taxes", we just mean how much you will pay for Social Security taxes and Medicare taxes.
Let's calculate Social Security taxes first. The way these taxes work is that you are charged 6.2% on the lower of your gross income, or $142,800 (as of the writing of this post in 2021, normally the limit changes every year). What this means is that if your gross income is above $142,800, you are capped at paying 0.062*142,800 = $8,853.60 in Social Security taxes. So our calculation will look like this:
Wages to put into Social Security formula = MIN($86,250, $142,800) = $86,250 Social Security taxes = 0.062 * $86,250 = $5,347.50
Now, let's calculate Medicare taxes. Medicare does not cap the amount of taxes you will pay. There is a flat rate of 1.45% for all gross income, except if you're above a certain gross income threshold, you also have what's called Additional Medicare Tax, which is 0.9% of the value above the threshold. The gross income threshold for Additional Medicare Tax was $200,000 for single filers, as of 2021.
For our example, we will just have the 1.45% for our gross income:
Medicare taxes = 0.0145*86,250 = $1,250.63 (For those of you who are super particular, it's technically $1,250.625, but I rounded up 😃)
So total FICA taxes are:
FICA taxes = Social Security + Medicare FICA taxes = $5,347.50 + $1,250.63 = $6,598.13
Baby Step 5: State Taxes
In addition to all the federal taxes you paid, you will also have to pay state income taxes. State income taxes are not all the same. There are some states with no income tax at all, such as Wyoming. There are some states where you have a flat income tax rate, like Colorado. And there are states with tax brackets for income (this is the majority case).
For this example, I will use CA state taxes. Like the federal income tax brackets, there are varying percentages for CA state tax brackets and they differ between different filing statuses. Let's use single filing status. As of 2021, these are the single filing status tax brackets for CA:
CA also has its own allowed deductions and credits. The standard deduction for single filing status in 2021 is $4,601. So our tax calculation for CA state income taxes will be:
CA AGI = $66,750 Taxable income = CA AGI - Standard deduction Taxable income = 66,750 - 4,601 = $62,149 State income taxes = 0.01*(8,932) + 0.02*(21,175-8,932) + 0.04*(33,421-21,175) + 0.06*(46,394-33,421) + 0.08*(58,634-46,394) + 0.093*(62,149 - 58,634) State income taxes = $2,908.50
So in total, you owe $17,220.63 in taxes, but keep a couple items in mind:
You are already getting a portion of your paycheck withheld for all of the taxes listed above.
Your sign on bonus was heavily taxed.
So if, from the beginning of this example, you actually had 40% of your sign on bonus taxed, that would mean 0.4*30,000 = $12,000 worth of your sign on bonus has already gone toward the taxes you owe. But, the federal and state governments don't adjust how much you should have withheld from each paycheck, even though the sign on bonus was heavily taxed. So what ends up happening is that by the end of the year, you have actually paid more in taxes than what you owe.
The way this issue gets addressed is that when you file your tax returns, both the federal and state government will calculate how much they owe you as a refund and you will either get 2 separate checks in the mail or 2 separate direct deposits (if you set that up), one for federal income tax refund and one for state income tax refund.
In this post, I discussed how to handle only cash-based compensation, but adding on RSUs, options, or other investment income is not too difficult because it will factor into your Adjusted Gross Income (AGI).
A natural question I get asked after explaining the concepts of this post to my mentees or my peers is, "Ok, do I have to do this calculation every year?" And the answer is, "Up to you!"
I personally do not calculate my taxes by hand every year because I have written scripts that will do that for me (so I am quasi-calculating by hand 🤣). But, they are also just estimates because they really only take standard income into account. Due to investment income, RSUs, etc., I just make sure to import all relevant tax forms (1099-Bs, 1099-INTs, 1099-DIVs, W2s, etc.) into TurboTax and I have TurboTax do all this work. So you could absolutely do the same thing if you like, or refer to a trusted CPA. But the point is, now you have the basics so that you could do this yourself and feel more comfortable with the tax returns process.
I hope this post was helpful to you and demystified how taxing works!