Understanding US Taxation — for folks starting out on H1B visa!
Saying that US tax system is complicated is something of an understatement! Around 58% of returns filed are done with the help of tax professionals! Just trying to understand all the fields in a W2 is likely to give us a headache, leave alone understanding a filled out 1040! And then there is a parallel state income tax system that varies from state to state.
But there are a few underlying themes in the tax system that we should understand, since they play a critical role in deciding the right investment setup and saving on taxes whenever we can.
For tax purposes, H1B visa holders are classified as Residents (if they have been in US for more than 183 days in the year) and must pay taxes on their “global” income in US. So, one must remember to declare any non-US income we may have in our countries. Depending on the Double Taxation Avoidance agreement US has with your home country you will get credit for any taxes paid in home country. Also, do not assume that if something is not taxable in India, it would not be in US also. For example, income from PPF accounts is taxable as per US tax law. A good accountant will usually guide you via a questionnaire to report all such reportable items. You may also need to file FBAR and FATCA depending upon how much foreign assets you may hold in accounts outside India.
Since most of our income will likely be from wages received from an employer, most of the tax paid is deducted directly at Source as per the choices you make while filling out a W4 with-holding form. Filling out this form properly as per instructions is important to avoid any year end surprise tax bills (and even penalty)! For example, if you with-hold too little claiming exemptions that do not ultimately apply to you, the actual tax bill may be more than the with-held amounts and IRS will demand the unpaid portion. (along with a penalty too if the penalty criteria are met!).
A lot of us forget about interest, dividend income, realized gains and overseas income when setting the with-holding rates. If we do not want to make separate estimated tax payments each quarter, we should increase out Federal and state with-holding amounts to cover for these.
Some people tend to with-hold extra to avoid any hassle later and this may be alright if the amount of refund you get is not too huge when you file return. Huge refunds are essentially zero interest loans from us to the IRS, since IRS does not pay any interest on excess taxes paid. (but it does demand interest on shortfalls! How very unfair!)
While calculating your Federal taxes, one starts with your gross income from wages (including bonus) and then any other income (dividends, interest, foreign income etc) is added to it. There are certain components that are not taxable (for example — Medical insurance premiums, commuter benefits etc), these are then deducted from it. Contributions to 401K and any tax-deductible IRA contributions are then deducted to arrive at your income for the current year. Please note that 401k and IRA pre-tax contributions are tax deductible when contributed but will be ultimately taxed in retirement when withdrawals are made (hopefully at a lower rate depending on your taxable income then). I will talk about 401K and IRA/Roth IRA in more detail later. Then comes in the standard deduction (or your itemized deduction if you choose to itemize) of 12,550 for single and 25,100 for married filing jointly (2021 numbers). There can also be other deductions, for example for dependent children or education related expenses depending on personal situation/income levels.
Let’s take a simple example to understand –
Suppose Naisha is single and has an annual income of USD 150,000 from wages, receives a USD 40,000 bonus for FY 2021. She also has interest income of USD 3,000 and foreign income equivalent to USD 7,000.
She contributed the maximum USD 19,500 USD to her 401k account. Her portion of the medical premium contributions added to USD 3,000. She also took the benefit of commuter account and contributed USD 2,400 to pay for commuting expenses.
Let’s calculate her federal tax, social security tax, medicare tax and state tax (assume NY state):
Please note that State wages are NOT the same as Federal, since every state has its own rules around what income it considers taxable and different deductions.
Please also note that 401K and Standard deductions do not apply to Social Security and Medicare Wages. Social Security taxable wages are capped at 142,800 for 2021 (meaning income above this amount is not taxed for social security contributions). Also interest and income other than wages is not part of Social security and Medicare wages.
If Naisha didn’t take advantage of 401K deduction:
· She would have paid $5,250 more federal tax in 2021 since some portion of her income would fall into the high 32% bracket!!!
· She would have also paid $1,234 more NY tax in 2021 since more of her income would fall into the 6.33% bracket.
I must point out that 401K contributions will eventually be taxed at retirement when withdrawals are made, but hopefully as a lower rate since your taxable income will be lower in retirement. One may be able to avoid state income taxes altogether in retirement on 401K distributions by relocating to a state like Florida that does not have income tax!
Hopefully this example helps you see the basic mechanics of income taxes in US!
