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continually tinkers with our nation’s tax laws. Bigger changes tend to occur when the same party controls both chambers of Congress as well as the Presidency. As this book goes to press in late 2021, we have been through a lengthy period where there has been lots of talk of tax increases by the Democrats, the party currently in control of Congress and the Presidency, but that has largely been blocked to date due to their super slim majorities in both the House and Senate.

With the 2022 Congressional mid-term elections on the horizon, history suggests that the most likely outcome for those elections will be divided government, which will mean even more gridlock and less likelihood for tax increases or tax changes in general. That said, here’s a short list of changes that have been discussed and that have the highest likelihood of being part of a tax package within the next year, if one ever passes:

       Higher federal income tax rates on high-income earners

       Some elimination of the step-up cost basis at death for investors in the highest tax brackets

       Expansion of the state and local income tax deduction from $10,000 to some higher amount

       Increased corporate federal income tax rate

       Higher federal capital gains tax rate for those in the highest federal income tax brackets

       Reduction in the federal estate exemption amount

       Application of the Social Security tax to more income for the highest income earners

Understanding the Different Types of Taxes You Pay and Your Tax Rates

      

Most small business owners pay income taxes at the personal income tax rates. That’s because the vast majority of small businesses are run as sole proprietorships. And many of those that aren’t, such as partnerships, LLCs, and S corporations, pass through their income in such a way that the income is generally taxed to its recipients as personal income. Some small business owners pay a corporate rate if their business is incorporated as a regular so-called C-corporation. (The type of business entity you elect is discussed in Chapter 2.) See the later section “Corporate income tax rates” for more details.

When it comes to federal income taxes, many people remember only whether they received a refund or owed money. But you should care how much you pay in taxes and the total and marginal taxes that you pay so you can make decisions that lessen your tax load. Although some people feel happy when they get refunds, you shouldn’t. A refund simply signifies that you overpaid your taxes during the previous year. When you file your income tax return, you settle up with tax authorities regarding the amount of taxes you paid during the past year versus the total tax that you’re actually required to pay, based on your income and deductions.

      In this section, I define important tax terms such as total taxes, taxable income, marginal tax rates, and corporate tax rates, and I also discuss the federal and state income tax systems.

      Defining total taxes and taxable income

      The only way to determine the total amount of income taxes you pay is to get out your federal and state tax returns. On each of those returns is a line that shows the total tax. Add the totals from your federal and state tax returns, and you probably have one very large expense!

      Your taxable income is different from the total amount of money you earn during the tax year from employment and investments. Taxable income is defined as the amount of income on which you actually pay income taxes. You don’t pay taxes on your total income for the following two reasons:

       Not all income is taxable. For example, you pay federal income tax on the interest that you earn on a bank savings account but not on the interest from municipal bonds (loans that you, as a bond buyer, make to state and local governments).

       You get to subtract deductions from your income. Some deductions are available just for being a living, breathing human being. And, the Tax Cuts and Jobs Act greatly increased the standard deductions. For tax year 2021, single people receive an automatic $12,550 standard deduction, heads of household qualify for $18,800, and married couples filing jointly get $25,100. (People older than 65 and those who are blind get slightly higher deductions.) Other expenses, such as mortgage interest and property taxes, are deductible to the extent that your total itemized deductions exceed the standard deductions.

      Your marginal income tax rate for federal income taxes

Marginal is a word that people often use when they mean “small” or “barely acceptable.” But with taxes, marginal has a different meaning. The government charges you different income tax rates for different portions of your annual income. So your marginal tax rate is the rate that you pay on the so-called “last dollars” you earn. You generally pay less tax on your first, or lowest, dollars of earnings and more tax on your last, or highest, dollars of earnings. This system is known as a graduated income tax, a system that goes back hundreds of years to other countries.

      The fact that not all income is treated equally under the current tax system isn’t evident to most people. When you work for an employer and have a reasonably constant salary during the course of a year, a stable amount of federal and state taxes is deducted from each paycheck. Therefore, you may have the false impression that all your earned income is taxed equally.

      Table 1-1 gives the 2022 federal income tax rates for singles and for married people filing jointly.

      

Your marginal tax rate is the rate of tax that you pay on your last, or so-called highest, dollars of taxable income. For example, according to Table 1-1, if you’re single and your taxable income during 2022 totals $55,000, you pay federal income tax at the rate of 10 percent on the first $10,275 of taxable income. You then pay 12 percent on the amount from $10,275 to $41,775 and 22 percent on income from $41,775 up to $55,000. In other words, you effectively pay a marginal federal tax rate of 22 percent on your last dollars of income — those dollars in excess of $41,775.

      After you understand the powerful concept of marginal tax rates, you can see the value of the many financial strategies that affect the amount of taxes you pay. Because you pay taxes on your employment income and your investment earnings (other than retirement accounts), you need to make many of your personal financial decisions with your marginal tax rate in mind.

       For example, when you have the opportunity to earn some extra money, how much of that extra compensation you get to keep depends on your marginal tax rate. Your marginal income tax rate enables you to quickly calculate the additional taxes you’d pay on the additional income.

       Conversely, you quantify the amount of taxes that you save by reducing your taxable income, either by decreasing your income — for example, with pretax contributions to retirement accounts — or by increasing your deductions.

      Actually, you can make even more of your marginal taxes. In the next section, I detail the painful realities of income taxes levied by most states that add to your federal income tax burden. If you’re a middle-to-higher income earner, pay close attention to the sidebar later in this chapter where I discuss the alternative minimum tax.

      State income taxes

      Your total marginal rate includes your federal and state income tax rates. As you may already be painfully aware, you

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