Concerned about taxes after raise

[Elaine]

Hi Everyone,
I feel like I've been posting like crazy lately so hopefully you aren't all sick of my questions yet! Also, before I begin let me be clear that I know this is an AWESOME problem to have. I'm 26 (not married, live in nyc, no dependents, rent my apartment, no car) and have been making 46k a year (before taxes), well I just got a big raise to 60k a year (before taxes). Am I going to get totally slammed on my taxes the next time I file? I'm not very good at math, but I'm really trying to improve (bad as in didn't get past pre-algebra in high school), is there a way to figure out how much I will owe? Also, maybe this is stupid, but is there some way I could offset the tax costs by just donating a bunch of money? My mom's friend runs an incredible charity, and honestly, I'd rather just give them 5k as a write off than pay the extra in taxes. How can I figure out how much I would have to donate to do that? Thoughts?

Also if anyone has advice on where I can learn more about personal finance math, I'd love to learn more how to do these calculations- half the posts here on MMM are over my head once he starts in on the calculations. Thanks! You guys have all been super helpful, especially for a young person who doesn't have any good money role models in their life.

[Kira]

Several thoughts here from a tax perspective. In short: the tax system does not work like that and you will be fine.

The US tax system is set up so that the first $x you make is taxed differently than the second $x you make. So you are never going to end up having a smaller paycheck after a raise than you did before because the raise portion will be taxed either the same percentage or a higher percentage than the rest, but the original amount will be taxed the same. http://taxes.about.com/od/Federal-Income-Taxes/qt/Tax-Rates-For-The-2013-Tax-Year.htm

Also, if your workplace is a relatively normal one, you probably filled out a W-4 when you started, where you told them how many dependents you had, etc. This gets fed into a calculation determining how much they need to take out of your paycheck. You probably have much more in taxes taken out a paycheck than someone making the same amount who has four children and a spouse - it's not the same for everyone. So those same calculations will automatically adjust the amount that gets taken out of your paycheck, and thus, you will end up owing/getting a refund in about the same amount you would have if you hadn't gotten the raise.

Third, if you don't have a mortgage, you probably wouldn't see any tax benefit from donating money. (Not that this should stop you!) But you should read up on the difference between standard deduction and itemized deduction (and not to toot my own horn but: http://www.moneycrashers.com/standard-tax-deduction-itemizing/)
Everyone gets to choose either the standard deduction OR the itemized deduction, and most people take whichever is larger. Your standard or itemized deduction is an amount that gets taken off your taxable income. The standard deduction for a single person for 2013 is $6,100. So because charitable deductions are part of your itemized deduction you would have to donate at least $6,101 before seeing any difference in your taxes.

In general, no worries about next year's tax time, you will probably not have much to pay if anything. Did you get a tax refund last year? If so, you will be just fine. You could actually ask your company if you can adjust your W-4 - this would mean that you would get more money in your paycheck but no refund at tax time. Getting a refund means you have let the government get an interest free loan on your money. :)

I am (other than taxes) not a math person, and I would generally say that you do not need to absorb all the math problem posts. If you are absorbing all the spend-less-make-more posts, and socking away the money, you can use many of the wonderful calculators and tools that are available out there and avoid doing the math yourself. ;)

[Villanelle]

With a graduated tax system, this very common concern doesn't really apply.

Your first 46k in income will be taxed exactly as it was taxed last year.  Same %.  Some of the income above that may be taxed at a higher rate, but you will still come out far better off than you were last year.

These are totally made up numbers, but the system works like this

First $10k of income, no taxes. Total tax bill is zero.   You keep all 10,000 if that is all you made.

Second 10k of income, 10%.  So the first 10k cost you nothing, and the second cost you $1k. So is you make $20,000 your tax bill is $1k and you keep $19,000

Third 10k of income, 12%.  So the first cost nothing, the second cost 1k, and the third cost $1200, so your total bill is $2200 and you keep $27,800.

As you can see, making more is always better and the first $x of your income is always taxed at the same rate, no matter how many more Xes above that you make.  This varies with deductions and other complications, but the basic system works that way for everyone.

If you want to make a donation, by all means, do so, but it isn't going to make you richer. 

[Elaine]

Wow, thanks for the information- this was really helpful. Looks like I'll just keep my habits the same and I should be good. I think I just wanted to learn the math because it feel nerve wracking investing money when I don't totally understand the mechanics of how the numbers work. But I'm jumping in by doing research anyway and I just invested $4,000 in a vanguard index fund- so now they can do the math :)

[geekette]

There are tax tables here if you want more specifics, but if your withholding last year worked for you, then withholding on the higher paycheck will still probably work just as well because they take these tables into account.

[Lans Holman]

2013 rates for an individual are 10% on the first 8,925, 15% on everything from there up to 36,250, then 25% up to 87,850.  These are good numbers to know because they tell you how much you are saving on anything that is tax free.  If you are making 60k and you find a way to keep that money from being taxed (IRA, 401k, HSA, deductions, whatever), you are essentially getting a 25% bonus on that money. 

The other misconception I think you have is about the charitable deduction.  As already pointed out, that only applies if you get above the standard deduction.  Beyond that, be sure you know the difference between a deduction and a credit.  A deduction gets subtracted from the amount you have to pay taxes on, a credit comes directly out of what you owe.  So if you donate that 5k ( even assuming this is above the standard deduction), it doesn't reduce your tax bill by 5k, it reduces your taxable income by 5k, saving you $1,250  (5,000 * .25).  Hope that helps.

[Iron Mike Sharpe]

I'd increase my 401K contribution if I was in your shoes.  I'm currently in the 25% tax bracket, but will be in the 15% tax bracket.  So, increasing my 401K contribution rate gives me more money in the long run.  I'm currently at 22% (can only go to 25%).  And I'm also fully funding a Roth IRA each year.

[jpo]

I'd increase my 401K contribution if I was in your shoes.  I'm currently in the 25% tax bracket, but will be in the 15% tax bracket.  So, increasing my 401K contribution rate gives me more money in the long run.  I'm currently at 22% (can only go to 25%).  And I'm also fully funding a Roth IRA each year.

This. Your raise will as allow you to nearly max out your 401k if you aren't already.

[sol]

I'd increase my 401K contribution if I was in your shoes. 

Thirded.  This is a golden opportunity to move your retirement up roughly two decades earlier in your life, just by allocating 100% of this one raise to your 401k plan. 

Not joking.  Do the math on this and you'll see your projected retirement date moves up roughly 20 years if you allocate this additional 14k to your 401k and make no other changes. 

Added bonus:  your taxes won't change at all, since all of the new income will be tax deferred (and likely tax-free upon withdrawal).  That's a better deal than a charitable donation, which you can always make later in life once you're financially independent.

[Elaine]

Would I really want to put all that in a 401k though? Isn't it important to invest it elsewhere as well? I currently put in up to what my employer matches, and will continue to, but if I want to retire early I thought a combo of index funds, IRAs, AND my 401k would be best.

[jpo]

There are differing opinions on that. MMM himself has a post on the blog addressing that question: http://www.mrmoneymustache.com/2011/11/11/how-much-is-too-much-in-your-401k/

[Kira]

Would I really want to put all that in a 401k though? Isn't it important to invest it elsewhere as well? I currently put in up to what my employer matches, and will continue to, but if I want to retire early I thought a combo of index funds, IRAs, AND my 401k would be best.

I think you may be confusing some items here.. you can buy index funds in either an IRA or a 401k. An IRA or a 401k is just a bucket that contains whatever investments you are allowed to put in it by the rules of the company that holds it. You may be thinking about after-tax versus pre-tax. In most situations, a 401k is pre-tax - you put money in before it's taxed, and then when you take it out you have to pay regular income tax on it. A traditional IRA operates the same way. This is versus a Roth IRA, where you pay tax on the money you put in, but then don't have to pay any when you take it out. When you leave your job, you can roll your 401k into a traditional IRA at another company.

There was an interesting article linked on The Mad FIentist from a while back - http://www.madfientist.com/traditional_ira_vs_roth_ira/ - I thought it had some interesting arguments and I'm generally following that plan. Basically the idea was that you will get the maximum benefit from socking away as much as you can in tax-deferred accounts like a 401k now when you are working, so you don't have to pay taxes on the money. Then when you are not working, you convert some of your traditional IRA to a Roth IRA. When you move money from a traditional IRA to a Roth IRA, it gets taxed like regular income.

However, as described above, there are break points in the tax code such that for any given person, the first $X amount of money isn't taxed at all. So if that amount is $30k and you made $22k in income that year, you could convert $8k of money from your traditional IRA to a Roth IRA and not have to pay tax on it because the whole sum is under that amount. Then later you can take the money out of the Roth without paying taxes. Effectively you have never paid taxes on that money! It's a really cool idea and uniquely applicable to those who are intending to have low incomes - the regular joes who are retiring on $50k a year could never do it. :)

Short answer: your taxes are highest right now, when you aren't married, and don't have children or a house. So it makes sense to avoid paying as many taxes right now as you can. Later in your life when your tax situation changes, you can change strategies.

[Crash87]

Regarding your 401(k) and getting money out for early retirement:

http://www.bogleheads.org/wiki/Backdoor_Roth_IRA