005 - How do Taxes Actually Work for a Drag Professional
On this episode of the podcast I dive into lesson 2 of my 12 part series of tax basics and legal fundamentals for the self-employed. We'll discuss your business profit and seeing how it works with all of the other elements of our income and expenses to calculate how much we owe in taxes.
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If you missed my intro episode or Part 1 of the series, take a pause and go back and watch those.
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Overview:
Net business income + All Other Income = Total Income for tax purposes
Total income - Adjustments = Adjusted Gross Income
Adjusted Gross Income - Standard Itemized Deduction = Taxable Income (this is what we calculate our taxes based on)
It's important to note that Owner Profit is the same as Net Business Income. In addition to Net Business Income, other income sources such as rental properties or spousal income al contribute to household income.
For example, if you have a W2 job and a freelance/1099 job, you may have multiple income sources counting toward your total income.
Let's assume we have exactly $100,000 in business income. Let's say you do a consultation with me and we find $10,000 in expenses you should be deducting. That brings total income down to $90,000.
Assume your tax bracket is 20%. 20% of $90,000 is $18,000, meaning the $10,000 you spent in expenses results in $2,000 in tax deductions. A deduction does not equate to a dollar for dollar reduction in taxes.
Adjustments = Personal Deductions (Part 2 on your tax form) You would subtract your adjustments from your total income. Your Adjusted Gross Income is typically the number that qualifies you for certain things i.e a mortgage or financial assistance from the government. $90,000 - $1,000 in AGI = $80,000
Take your AGI and subtract the Standard Deduction (or Itemized Deduction). This amount can increase year by year due to inflation. For example, last year for single individual it was $12,200. $80,000 - $12,200 = $67,800
On the Schedule A form we also look at Itemized Deductions, this includes things like Medical Expenses, Gifts to Charity, Taxes You've Paid, etc. These are like expenses, but the IRS makes them different. You can add all of them up but the catch is you only get to take the Standard Deduction or the Itemized Deduction. Typically people are only itemizing if they own a home and have a large mortgage, otherwise the Standard Deduction is usually more beneficial.
Once we have our taxable income, it's calculated based on the IRS tax brackets. Your tax bracket, and therefore your tax rate, is based on your taxable income, not total income. You pay tax percentage based on the bracket you're in at any given time. Once your taxable income goes up to the next bracket, then you start paying that tax percentage on that income, moving up level by level and paying each percentage just on the income in that bracket.
Marginal Tax Rate = Tax Bracket
Effective Tax Rate = Amount You Actually Pay
Once we have taxable income and calculate our income tax, then we have tax credits which is a dollar for dollar reduction in your taxes. Different from deductions, tax credits are for different scenarios, such as having children.
In addition to our Federal Income tax, we also have our Self Employment Tax which is 15.3% and covers our share of Medicare and Social Security up to certain income thresholds and then it drops to 2.9% tax that is the portion for Medicare.
We also need to consider State Income Tax (unless you are in a no income tax state).
Book a consultation with me here to discuss your taxes, bookkeeping, and more.
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