I don't understand how taxes work

Alright, I've seen a good deal of misinformation floating around with regard to income taxes, especially as it pertains to bankers' compensation, so I'm going to try and provide a little primer here. Might be a bit long / rambling, but hoping this might help some folks understand their tax situations (I'm not a tax professional, this isn't tax advice blah blah blah):

How Taxes Work

• First, let's make what is perhaps an obvious but important distinction; there is a difference between taxes withheld and taxes due
• Taxes withheld are merely an estimate, based on your payroll throughout the year, of what will be your total taxes due when you file; the Feds like to smooth out their tax revenues rather than waiting to get it all as a lump sum during tax season, so they make employers send them these withholdings throughout the year
• Taxes due are determined when you file your taxes in April of the following year; your taxes due are equal to the effective tax rate as calculated based on your total income (i.e., salary + bonus) for the preceding calendar year, adjusted for any deductions (usually just the standard deduction, which is currently ~$13k but typically indexed for inflation)
• So, your tax liability (i.e., incremental taxes owed at filing) is: Tax Liability = (Total Effective Tax Rate * Taxable Income) - Taxes Withheld
• If your total taxes due (determined when you file) are greater than the taxes you've withheld (throughout the year), you will have a tax liability (i.e., owe the IRS more money) or will be due a refund if the opposite is true

Why Bankers Almost Always Owe Additional Taxes When They File

• Due to the payment of large, lump sum bonuses, bankers will almost always owe additional taxes when they file; explanation below:
• Your salary is withheld at an annualized rate based on regular federal / state / local brackets (e.g., if you're getting $20k per month, your salary will be withheld at an effective rate equivalent to what would be your taxes due if your total taxable income for the year was exactly $240k)
• Your bonus will be withheld at a flat rate of 22% federally (at state / local level, usually taxed at flat rate equivalent to highest marginal bracket)
• When you file your taxes in April, you aggregate your salary and bonus paid in the preceding year, and calculate your total taxes due based on that amount (again, less adjustments for standard deduction, etc.); so, when you file, your salary and bonus are treated exactly the same for tax purposes, even though they are withheld at different rates during the year
• Because your bonus is "only" withheld at 22% federal, and because your salary is being withheld on an annualized basis ex. bonus, bankers will almost always have a significant tax liability when filing, because actual taxes due on your bonus will likely be greater than 22%, and because your salary has been withheld as though you were not being paid a bonus (i.e., your bonus increases the effective rate of taxes due on your salary, and your salary increases the effective rate of taxes due on your bonus, but your withholding throughout the year doesn't account for this - this effect is only captured when you file during tax season)

Example of Banker Tax Liability Calculation

• This is a simplified example which ignores the impact of stock awards, state / local taxes, and payroll taxes (i.e., the ~7.65% FICA tax), as well as the fact that bankers' salaries typically change mid-year - I've included some notes on these topics in the 'Other Considerations' section
• These are all hypothetical numbers obviously, but based on current tax rates assuming single filer should be pretty accurate:

Example:

• Let's say you have a salary of $225k for the entire calendar year (20x3), and you were awarded an all-cash bonus of $250k in the prior year (20x2)
• Your salary is being withheld at a federal rate of ~$2,200 per payroll cycle (effective rate of ~23%); so, your annualized salary withholding for 20x3 is ~$52,500
• Your $250k bonus, awarded in 20x2, was paid out on March 31st of 20x3, and was withheld at a rate of 22%; so, your bonus withholding for 20x3 is ~$55,000
• Therefore, your total federal income taxes withheld for 20x3 are $107.5k
• On April 15th, 20x4, you file your taxes for 20x3; your gross income for 20x3 is your $225k salary plus $250k bonus = $475k
• You claim the standard deduction, which is ~$15k, so your taxable income for 20x3 is $460k
• The effective federal tax rate for $460k of taxable income is ~29%, so your total federal taxes due for 20x3 are ~$135k
• Your total tax liability is $135k (total taxes due) less ~$107.5k (total taxes withheld throughout the year) = $27.5k

How Bankers Can Estimate Their Tax Liability for the Current Tax Year

• At the end of 20x3, you are awarded a cash bonus of $300k, to be paid on March 31st of 20x4; your salary is increasing to $275k for 20x4
• You estimate your federal tax liability for 20x4 by using a take-home pay calculator online to complete the following steps (I recommend SmartAsset, or you can build an Excel if you're feeling ambitious):

1. Calculate federal withholding on your annual salary for 20x4: $275k * ~25.5% = ~$70k
2. Calculate withholding on your bonus awarded in 20x3: $300k * 22% = ~$66k
3. Calculate taxes due on your projected total taxable income for 20x4: $275k + $300k - $15k (standard deduction) = $560k * ~30% = ~$170k
4. Subtract estimated taxes withheld from estimated taxes due: $170k - $136k = $34k estimated tax liability for 20x4 (due when filing in 20x5)

Other Considerations 

• If you receive stock awards as part of your bonus, you can choose to either 1.) have the full amount taxed immediately as regular income, and only pay capital gains on any subsequent appreciation, or 2.) elect to defer taxation until the stock vests, and pay regular income taxes on the full amount at time of vesting
• Have seen most people go with Option 2 to match timing of taxation with liquidity of the underlying award, but if you think your employer is a rocket ship and have cash to pay taxes on the unvested stock, I guess could go for Option 1
• You can estimate any state / local tax liabilities using same method for federal, though liabilities here will typically be lower or nil given state / local taxes may not be progressive (i.e., flat rate versus bracketed) or bonuses might already be withheld at top marginal rate (e.g., if you live in New York, you will likely see a partial refund on your state taxes for this reason)
• Your payroll taxes (i.e., SS and medicare) are withheld at constant rate (6.2% for SS, 1.4% for medicare) so you typically won't owe anything incremental here when filing
• SS taxes are capped (currently at $160,200 of income), so you should see your take-home paycheck get bigger after you cross that threshold for the year, as your employer will typically stop withholding SS taxes once you've hit the cap (though, if you switch employers, sometimes your new employer will just reset the cap, and so you may actually get a refund on SS taxes when filing due to double withholding throughout the year)
• Medicare tax has no cap, and I think now there's an incremental 0.9% tax applied to income over $200k
• Since bankers' salaries typically change mid-year, to calculate your estimated salary withholding more precisely, you'd technically take your salary at start of the year, estimate full-year withholding at that amount, and multiply by (x/24), with x being number of pay periods at BGN salary rate, and then add that to your estimated full-year withholding at new salary rate * ((24-x)/24)

Tax Management / Repayment Strategies

• Once you estimate your tax liability for the year, you can throw that amount in a CD or high-yield savings account or something with maturity at/before April of next year (or can calculate amount needed to fund tax liability, net of interest, and then take the difference to the casino)
• Also, the IRS lets you set up long-term payment plans for any tax liabilities under $50k; there is interest + penalties, but really not that punitive (this year, my effective rate on tax repayment plan was like 7-8%); it doesn't impact your credit or standing with the IRS, and you can essentially choose how much you want to pay each month, with terms extending out as far as 72 months (though I typically would set it up to be 12-pay to terminate at next tax filing); can google IRS installment agreements for more detail, nice way to potentially spread out tax payments versus having to stroke a large check to the IRS right after filing taxes

Anyway, hope some of this is helpful - cheers.