2022 Tax Guide for Young Lawyers
Executive Summary
Taxes are a part of every lawyer’s financial life. Taking advantage of tax deductions and credits to reduce your taxes can directly increase your annual spending on things you enjoy much more. It starts with understanding how income taxes are calculated for salaried lawyers. After determining taxable income, lawyers will apply the deductions that lower their taxable income even further. Finally, qualifying for tax credits can lower your tax bill dollar-for-dollar. By better understanding all of the available tax deductions and credits, lawyers can more intelligently spend their money to maximize their happiness and hopefully lower their tax bill.
Tax Day may be the least favorite day on the calendar for most Americans. It is the last day to file your taxes for the previous year. By Tax Day, people who will receive a refund have already likely filed. For everyone else, it is the final day to file and pay. Not fun.
Few people like filing their taxes, and almost no one likes paying their taxes. While we cannot ignore the filing requirement, there are things that lawyers can do to reduce their taxes owed and maybe even receive a refund.
This 2022 Tax Guide for Young Lawyers will discuss some tax information regarding earnings, deductions, and credits, but there are certainly more strategies than this guide can cover. Additionally, you should consult a tax professional before implementing any transactions and/or strategies concerning your finances. This guide is for educational and informational purposes only.
What taxes will a young lawyer pay?
While there are many different types of taxes that a lawyer will pay over their life, the taxes in this article will focus on direct taxes. Indirect taxes are taxes like sales taxes. Technically we pay for them, but the seller, not the buyer, will pay that tax to the IRS. Direct taxes include income taxes, capital gains taxes, and property taxes.
Income taxes
When thinking about income taxes, lawyers should know three things: their tax bracket, their marginal tax rate, and their effective tax rate. Young lawyers should also be aware that because they are salaried and not partners, they will receive a W-2 annually. The W-2 form documents the pay earned for a year and the taxes withheld for those earnings.
Tax brackets
The tax bracket you fall into is significant because it affects how much you will pay in taxes. The tax brackets for 2022 are:
Your tax bracket is not the only tax rate that determines the amount of income taxes owed. Instead, the calculation for income taxes owed uses the tax bracket you fall in as well as the lower tax brackets. Income taxes apply to each tax rate at each tax bracket income limit to account for all earnings.
Say a single lawyer makes $150,000. That would put them in the 24% tax bracket but they would not owe $150,000 * 24% = $36,000. Instead, a lawyer would owe:
While they are in the 24% tax bracket, they do not owe 24% of their taxes. Instead, their effective tax rate is $29,836 / $150,000 = 19.9%. The effective tax rate is typically lower than the tax bracket of a lawyer.
The effective rate is also usually different than your marginal tax rate. The marginal tax rate is the current tax rate applied to $1 more of income. If a lawyer in the 24% tax bracket earns another $1, the tax rate on that dollar is 24% and not the effective tax rate. Both marginal tax rate and the effective tax rate of a lawyer describe different aspects of their tax situation. Effective tax rate describes the total taxes paid compared to how much was earned. The marginal tax rate describes how much taxes are owed on additional income.
In addition to Federal income tax, W-2 employees will also pay their portion of Social Security and Medicare taxes. Lawyers will pay 6.2% of their salary to Social Security for the first $147,000 they earn. Lawyers will also pay 1.45% for Medicare taxes with no limit on taxable earnings. For single lawyers earning more than $200,000 and married lawyers jointly earning over $250,000, you may also owe an additional 3.8% on net investment income (interest, dividends, capital gains, rental income, etc.) and 0.9% for additional Medicare taxes.
Withholdings
When you begin working for an employer, you likely completed a W-4 form. This form informs your employer how much of your pay to withhold for tax payments. Americans need to have their pay withheld or else pay estimated quarterly tax payments. Neglecting to withhold or make quarterly payments can result in tax penalties when someone files their taxes. Your withholdings affect both your current pay and future tax liability.
If you fill out the W-4 and have a greater withholding than you need, your paychecks will be lower since your employer withholds more of your salary for taxes. These higher withholdings also mean you are more likely to receive a tax refund when you file your taxes. Vice versa, if your withholdings are lower than you need, your paychecks will be higher, but you may owe money on your tax return when you file. If your withholdings are too low, you may even owe a tax penalty for not withholding enough throughout the year.
While it may be nice to receive a tax refund every year, it may not be a financially prudent action. That is because the government does not reward you for overpaying your taxes. If you have a refund of $1,000, the government will pay you exactly $1,000. Instead of paying the government $1,000 extra over the year, you could have used that $1,000 to pay for things or invest. Your money is almost always better off in your possession than held as a future refund from the government. When filling out the W-4, be honest and accurate. This is the best way to withhold the Goldilocks amount: not too much, not too little, just right.
These W-4 withholdings will be for income taxes, but the employer will also withhold taxes for Social Security and Medicare taxes.
Capital Gains
In addition to income taxes, lawyers who invest will also see capital gains on their income tax forms. Almost everything you own or invest in is a capital asset. When you sell a capital asset like a home or a stock, you will owe taxes on the difference between what you paid and what you received.
A lawyer buys a stock for $90 and later sells it for $100, the $10 gain is taxable as a capital gain.
Capital gain taxes are different based on how long someone owned the capital asset. The tax code splits them into short-term and long-term capital gains/losses. Short-term gains/losses are for any gains or losses on the sale of a capital asset within one year of purchasing the capital asset. These gains and losses are taxed using your marginal tax rate.
A lawyer in the 24% tax bracket buys a stock for $90 in January and sells it for $100 in July. They will owe $10 * 24% = $2.40 in capital gains taxes.
Long-term capital gains/losses have a preferential tax rate based on the tax bracket. A capital asset is long-term if owned for at least one year and one day. These tax brackets are:
A lawyer in the 24% tax bracket but the 15% long-term capital gains bracket buys a stock for $90 in 2020 and sells it for $100 in 2022. The lawyer will owe $10 * 15% = $1.50 in capital gains taxes.
It may not always make sense for a lawyer to hold onto a capital asset for over a year just for the tax savings. But it is an incentive to avoid selling capital assets within a year.
Deductions
Deductions are one of two ways to lower your taxable earnings. Lawyers who take advantage of available deductions can decrease their annual tax bills. These deductions are also typically designed to incentivize people to take some financial action. So by using a deduction to minimize your taxes owed, you might also be adding positively to your financial situation through your spending.
Standard vs. Itemized deductions
The most well-known deductions are the standard and itemized deductions. Taxpayers will always choose which one they would like to apply to their taxes. You can only choose one, so choose the one that lowers your taxes owed the most.
In 2022, the standard deduction for single filers is $12,950, and for married filing jointly filers, the standard deduction is $25,900. Lawyers who choose the standard deduction will reduce their taxable earnings by the deduction amount.
A single lawyer is in the 24% tax bracket and has $150,000. By taking the standard deduction, their taxable earnings are now $137,050. It results in a tax savings of $3,108. You can estimate the tax savings by multiplying your marginal tax rate (24%) by the standard deduction amount ($12,950).
Itemized deductions are not a set amount each year. Instead, specific spending throughout the year determines the itemized deduction amount. Lawyers should always add up all itemized deductions and compare them to the standard deduction amount. If itemized deductions are higher, it makes more sense to itemize your deductions instead of taking the standard deduction. Some common itemized deductions lawyers should know include:
Unreimbursed medical and dental expenses
State and Local taxes include state and local income taxes, sales tax, real estate taxes, and personal property taxes. The SALT (State and Local Taxes) deduction is limited to $10,000.
Home mortgage interest
Gifts to charity
Casualty and theft losses from a federally declared disaster
Gambling losses (only up to gambling winnings)
Since the 2019 Tax Act passed, most Americans will take the standard deduction, but it is always worth comparing to make sure.
Other deductions are not a part of the standard or itemized deductions. Lawyers should consider taking advantage of these because they can adjust your taxable earnings lower if you are eligible for them. They include:
Student Loan Interest: Deduct up to $2,500 in paid off student loan interest
Capital Losses: Capital losses can offset capital gains. If capital losses exceed capital gains, up to $3,000 of capital losses are deductible.
Traditional IRA contributions: Can deduct contributions, if eligible. Eligibility depends on access to a retirement plan at work and income limits.
Traditional 401(k) contributions: Traditional 401(k) contributions are not taxed up to $20,500. Employer matches are also not included in taxable income.
Health Savings Account (HSA) contributions: $3,600 for single filers and $7,200 for married filing jointly filers
Sale of home: Exclude $250,000 for single filers and $500,000 for married filing jointly filers of gains from the sale of a primary residence that a lawyer has lived in and used for 2 of the last five years.
These tax deductions are not only good for reducing your tax liability, but they can also lower your taxable earnings enough to avoid a higher tax bracket and marginal tax rate. Remember that saving $1 on taxes means you have $1 more to spend. Every little bit helps.
Tax Credits
Tax credits are different from tax deductions because they offer more tax savings than deductions do dollar-for-dollar. How so?
Example: A lawyer in the 24% tax bracket can choose between a $5,000 tax deduction or a $2,000 tax credit. You may think that the deduction is better because it is $3,000 more, but that is not the case. A deduction reduces taxable earnings, while a tax credit reduces the taxes owed by a taxpayer. A $5,000 tax deduction would save a taxpayer $5,000 * 24% = $1,200 in taxes owed. Meanwhile, a $2,000 tax credit reduces the taxes owed by $2,000.
Some tax credits are also refundable. Meaning that if a taxpayer owes taxes before a tax credit is applied, if the tax credit exceeds the taxes owed, the taxpayer can receive a tax refund.
A lawyer owes $700 in taxes before applying a $1,000 refundable tax credit. After taking this tax credit, the taxpayer will now receive a $300 tax refund instead of owing $700 in taxes.
Most tax credits are nonrefundable, but it can be financially rewarding if you are eligible for the refundable tax credits.
Here are some of the most common tax credits available to salaried lawyers:
Child tax credit (refundable): up to $3,600 per child
Child and dependent care tax credits (nonrefundable): Applies for both child daycare and dependent care expenses for spouses or parents unable to care for themselves. Deduction amounts vary depending on income levels and the number of dependents.
Lifetime learning credit (nonrefundable): reimburses 20% of the first $10,000 of qualified education expenses for lawyers under an income limit.
Adoption Credit (nonrefundable): $14,440 per adopted child for qualifying adoption expenses.
Earned Income tax credit (refundable): $1,502 - $6,728 for taxpayers depending on how many kids you have, marital status, and earnings.
Saver’s credit (nonrefundable): potentially up to $1,000 depending on the dollar amount of contributions made to qualifying retirement plans and your annual earnings.
Residential energy credit (nonrefundable): up to 26% of the installation costs for solar energy systems like water heaters and solar panels
Many of these available tax credits are for lower-income households. BigLaw lawyers, highly paid in-house counsel, and other private lawyers will likely not be eligible for many of these credits. For lawyers working in public or non-profit jobs, you are more likely to qualify for them.
Final Takeaway
There are opportunities for lawyers to reduce their annual taxes owed by taking advantage of eligible tax deductions and credits. Do not think that having a "simple" tax situation means you cannot lower your taxes. Some common ways to reduce the chances of surprise tax bills on Tax Day include:
Have an appropriate withholding on your salary
Minimize selling investments in taxable investment accounts (day trading)
Calculate and compare itemized vs. standard deduction amounts
Take advantage of eligible deductions and credits
Taxes have a direct impact on the spending of a lawyer. Saving $1 in taxes means you have $1 more to spend on your life. Like many other aspects of a lawyer’s financial life, it is better to be proactive rather than reactive. As a CPA, I have developed a process to analyze your prior income tax forms and current financial situation to identify future tax opportunities to hopefully lower your tax bill. If you would like to learn more about how tax planning can take proactive steps to reduce your income taxes instead of a reactive approach to pay for surprise tax bills, schedule a Meet & Confer.
Disclaimer: Nothing in this blog should be considered financial advice or recommendations. Your questions are unique to you and your own personal financial circumstances. You should consult with a financial professional before making a financial decision. See full blog disclaimer.