W2 Employees and Taxes: the American Plight

Despite being a country founded on a revolution against tax (on tea), in 2022 alone, the federal government collected $2.9 trillion in income and estate taxes¹. That’s almost the equivalent of the 7th biggest country in the world measured by GDP². Given its magnitude and far fetching reaches, taxes should be a topic all Americans should be conversant and comfortable with.

As complex as the tax system has gotten, however, most Americans following the American Dream Track will find their taxes are relatively simple. We’ll define the American Dream Track here as: a 9-to-5 job as a W2 Employee, eventually owning a house with a mortgage, and having some money in the stock market. We’re going to explore what taxes look like for the typical American.

• First, we’ll map out what the typical evolution of a W2 Employee is and how that affects their taxes
• Then, we’ll dive into what we see as common tax filing pitfalls that we’ve run into
• Lastly, we’ll briefly touch upon how the tax burden grows with your income and ways to save on taxes

American Dream Track: the W2 Employee

First off, what is a W2 Employee? You are classified as an employee if you have signed an employment contract which establishes your relationship with your employer as such in legal terms. Your employer will generally have in place an HRIS (short for Human Resources Information System) in order to set up your HR records, get you paid, withhold for taxes, and do most of the heavy lifting when it comes to reporting the data come tax season. Your employer will issue you a W2 which outlines your taxable income along with tax withholdings and any other relevant tax deductions on the W2 form. Your job is to review your W2 and use that information to file your taxes at year end on the 1040 form.

The Life Stages of the W2 Employee

A W2 Employee progresses through different stages in their life and career. At each stage, their taxes also take on new dimensions of complexity.

• Employee Only
  ‍As a fresh grad starts out, they’ll likely be an employee and have an interest bearing bank account. Their typical tax preparation is relatively easy constituting of the W-2 form from their employer detailing their income and related deductions. They may possibly receive a 1099-INT form from their bank for interest earned greater than or equal to $10.
• Employee with Some Assets
  ‍As they progress in their career, maybe they’ll add an after tax brokerage account. Their set of forms will still remain easy: W-2, 1099-INT, 1099-DIV, and 1099-CONSOLIDATED. The 1099-DIV and 1099-CONSOLIDATED will likely come from their brokerage detailing capital gains and losses from the purchase and sale of stocks, bonds, ETFs, funds, etc.
• Employee with Some Assets Plus a House
  ‍At some point, they’ll buy a house with a mortgage. Even then your tax forms only get slightly more complicated. They have all of the forms that they previously had and will now also receive a 1098 form which details how much mortgage interest they paid. If they pay their own property taxes (not bundled with their mortgage payment), they will also need to report the property taxes paid. Both the mortgage interest and property taxes are beneficial homeowner’s tax deductions if the total exceeds the standard deduction. Some home improvements may also be considered as tax deductions, particularly solar panels or other energy efficient improvements.

Summary Table of W2 Employee Tax Evolution

The above scenario typically encapsulates the progress of tax complexity over time for individuals, which remains relatively simple. The general tax situation should be covered by the tax withholdings done by your employer’s payroll process. The remainder of the information needed would then be available from the bank and the brokerage firm.

Most of the information is neither prepared nor tracked by the tax filer. This system reduces tax filing errors, but also renders the filer less knowledgeable about their personal tax situation.

Common Pitfalls for W2 Employee

TurboTax, H&R Block, and similar tax software have made the business of filing taxes much easier. The burden of ensuring the filing is up to date with the tax code falls upon the software. The filer’s responsibility is to ensure the accuracy of the filing, which is mainly ensuring the inputs are accurate and complete. The common tax pitfalls we outline here are predominantly due to human error.

Under Withholding

Under withholding means that the amount set aside for taxes during each paycheck payroll processing is insufficient to cover your federal income tax obligation. The amount withhold is estimated on your behalf by the payroll processing system based on your inputs completed on form W-4 during HR onboarding.

This happens for a variety of reasons such as:

• Incorrectly filling out form W-4 for withholding,
• “Married filing jointly” and misestimating spouse’s income, or
• Underestimating income from other sources of income such as investments, interest, and dividend income.

Missing Tax Forms

Even with TurboTax’s automation, “garbage in, garbage out” still aptly applies to tax filing. The filer’s primary job becomes ensuring the data they provide and input is complete and accurate. Therefore, a great risk to the filer is ensuring all the relevant forms are gathered and inputted correctly. Missing a tax form can alter tax obligations, some times significantly.

Messing Up a Rollover

A rollover is the process of moving a financial account from one brokerage firm to another firm, or sometimes changing the account type. Common rollovers that people encounter are usually a 401K to IRA rollover or a post-tax brokerage account being moved from one investment firm to another. People may want to do these rollovers to consolidate their accounts, reduce management fees, or work with a new platform or advisor.

Regardless of the reason, if done correctly, 401K and Investment account rollovers should not result in any taxable income because the rollover should be transferring assets “in kind”. “In kind” means the previous account titling is the same as the new account. In most instances, the account type are the same as well with the 401K to IRA being a notable slight deviation. Therefore, in an “in kind” transfer, the account itself changes but the underlying assets are not bought or sold; and no capital gains or losses are realized.

Messing up a rollover, where all assets are inadvertently sold, can lead to an unintended tax bill.

Alternative Financial Assets

Alternative financial assets we define here as assets outside of stocks and bonds. Tax reporting for stocks and bonds are relatively straightforward with the brokerage doing the heavy lifting when it comes to preparing the data and issuing the year end tax statement. Traditional assets like a primary home, a 401K or brokerage account are supported by the infrastructure from banks and brokerage firms. This makes the job for tax filers far simpler: gathering documents, and inputting data into tax filing form or software.

Assets that require self-prepared data for tax filing or are poorly supported from the issuer, are the situations that can get taxpayers into trouble.

• Self-prepared data: An example of an asset which requires extensive self-prepared data would be income and expenses from rental properties.
• Poorly supported from issuer: An example of a poorly supported function from the issuer are stock options from an early stage startup. This is predominantly because stock option management is neither as automated as payroll nor can it be.

Some general examples of assets that may require more attention to ensure proper filing are:

• Rental Properties (short-term AirBnbs and long-term rentals)
• Cryptocurrencies (particularly from less established exchanges)
• Stock Options (ISOs, NSOs, RSUs, etc.)
• Artwork
• Venture investments

Considerations for Saving on Taxes

Through hard work and dedication, a W2 employee’s income grows over the course of their career. However, W2 employees don’t anticipate how much taxes eat into their earnings. The Federal marginal tax rate jumps from 24% to 32-37% for every incremental dollar in income for Single filers with an aggregated gross income (AGI) of $191K+ or Married Filing Jointly with an AGI of $384K (in 2024). That doesn’t include state tax which can run as high as 12.47% in New York and potentially local city or county tax such as New York City’s progressive income tax of ~3%.

Not surprisingly, higher wages coincide with higher cost of living as well as typically higher state and local taxation.

Taxes are Punitive for Household Income >$350,000

Yet optimizing for lower taxation can hurt your career progression because areas typically with lower taxation also have lower paying jobs. For example, minimum wage in New York City as of January 2024 is $16 per hour compared to Georgia where the minimum wage is $7.25 per hour. The result? More income is needed to be middle class in more expensive metropolitans.

For high income earners, taxes become the household’s biggest expenditure. Therefore, educating on taxes translates to optimizing for savings.

Lower Salary + Higher Benefits = Tax Savings

Balancing the tradeoff between salary versus benefits is a common dynamic in negotiating compensation. The payoff from benefits becomes even more pronounced when every incremental $1 on a salary only translates to 50 cents in take home pay. Benefits provided by the employer, depending on what it is, isn’t necessarily taxable income, such as:

• Employer matching for retirement contributions is a no brainer way getting compensated more while paying yourself first. Some companies max out at 4% match; that’s roughly another thousand dollars pre-tax per year if the employee maxes out their 401K contribution.
• Better insurance, including medical, dental, vision, long-term care, disability insurance, and life insurance
• FSA and HSAs, with HSA being a significant financial vehicle to save for medical costs
• Commuter benefits, some commuter benefits can be considered additional income, so it’s important to understand how those are structured by your HR and Finance departments
• Reimbursement for company related expenses, such as organizing company events, traveling for the company, and/or equipment for work

The last category by far has the biggest potential for savings and perks. For example, if you’re traveling on behalf of the company extensively, consider making the purchase on your personal credit card (company policy permitting) and then expensing that back to the company. For those with wanderlust, this mechanism can set you up for extensive free travel later on, which is why we’ve dedicated an article to it here: Travel for your company? Travel Hacks to Make you Money.

Alternative Compensations

We’re adding here two compensation add-ons that we’ve seen may have some potential for tax savings. Both are rather rare compensation models, so don’t count on your employer having them. Additionally, given their complexity, we highly recommend anyone who receive these benefits to do their own research and homework on the specifics:

• Pre-Tax Profit Sharing: By far, this is the best way to receive a bonus. We haven’t come across this compensation model often. In this model, a profit sharing bonus plan has been structured to pay a portion of the bonus into a pre-tax investment account. This allows the employee to keep more of their bonus than a straight cash bonus. The additional benefit is allowing employees to contribute above the set 401K retirement contribution limits.
• Stock Options: Public equity comes with high risk. Stock options from a private company are probably even riskier. Not surprisingly, investors who target private company stocks typically have to be accredited. For employees, stock options can be a potential boon even if it’s a moonshot. There’s the added bonus that stock options that have been exercised and held long-term are subject to long-term capital gains tax instead of your income tax rate. As with any complex financial asset, remember to read the fine print and understand how the asset works.

Max Out Pre-tax Retirement Contributions

This one is a no-brainer, but too many individuals do not do this. Therefore, this deserves its own callout in all caps:

Max out your entire retirement contributions

401K contributions up to the maximum of $23,000 per year is tax free in 2024. This money is also contributed directly into the retirement account. 401K contributions puts a person’s savings on auto-pilot, following the adage: “pay yourself first”. Taxes are due upon withdrawal, but the invested cash and earnings are allowed to grow tax-free until withdrawal.

If you are eligible, investing in a Roth IRA might be a better alternative. Regardless, maxing out retirement contributions is step one in setting towards building long-term wealth.

Being Self-Employed May Help with Taxes

For self-employed individuals, some of the biggest tax benefits come from being able to deduct business expenses such as the home business deduction, deducting the costs of computer and equipment, and even wi-fi or utilities for work. If enough is earned, there are also more complex legal and tax classification structure than help owners contribute more towards their retirement than the 401K limit of $23,000 per year.

Avoid Major Metropolitans with City Income Taxes

New York City and San Francisco are just two of the major metropolitan cities that charge city income taxes in addition to the State and Federal income taxes. Although there are a multitude of benefits to living in large metropolitan areas when it comes to lifestyle options and career progressions, the added hidden costs may not be for everyone. One of which are the added tax burden.

Don’t Let Taxes Surprise You

Income taxes seem straightforward enough. However, it’s easy to make unintended mistakes.  Not only that, but as a hardworking American earns more, their tax burden increases. To the point that after federal, state, and local taxes, some high earning Americans bring home less than half of their gross paycheck. Taxes have become the common American’s greatest expenditure.

Don’t let taxes surprise you:

• Avoid common pitfalls due to filer’s error such as missing forms and poor record keeping
• Understand tax obligations at federal, state, and local levels
• Research the options on how to reduce tax burden

Taxes are a responsibility. However, for many middle and upper middle class Americans, taxes are one of the many responsibilities on a growing list of financial burdens: student debt, childcare, healthcare, and retirement planning, sometimes for themselves and their parents. When inflation is high and wages are stagnant (like right now), the burden of taxes can be punitive. Plan ahead for taxes; and lessen the stress on yourself and your loved ones by being prepared.

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Related Articles

Why Good Personal Finance is Necessary for Running a Business

Pay off Your Mortgage or Invest

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Citations: 

[1] https://www.irs.gov/pub/irs-pdf/p55b.pdf

[2] https://en.wikipedia.org/wiki/List_of_countries_by_GDP_(nominal)

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Further Reading: 

[A] https://www.investopedia.com/articles/tax/10/concise-history-tax-changes.asp

[B] https://www.efile.com/tax-history-and-the-tax-code/