Albert Einstein once said, “The hardest thing in the world to understand is income tax.” I’m sure that most accountants will agree that for every tax problem there is a solution which is straightforward, uncomplicated, and completely….wrong. Taxes may not be the easiest to understand but there are few things that are more certain in life as the need to pay taxes. Taxes are a seemingly necessary evil. In this article I am going to discuss some of the basics of income taxes and tax brackets along with sharing some examples to help everyone understand how our tax system works.
Let’s Start With the Basics
Tax is the money collected by the government to basically pay for everything the government does. Most people and businesses work to earn money, or an income, and the government takes part of that money as a tax. This is where we get the term income tax. Failing to pay income tax is a very serious offense. The various government tax systems around the world all vary. Some countries levy a flat percentage rate of tax based on personal annual income, some on a scale based on annual income amounts, and some countries impose almost no tax on their citizens. For example, the Bahamas and the Cayman Islands do not charge people or businesses any income tax at all. To make up for the lack of income tax in the Cayman Islands they impose a 25% import tax, a 13% tourist tax on all hotels and accommodations, and departure taxes at the airports. Anyway, let’s get back on point and discuss taxes here in the U.S.
The U.S. Tax System
I agree with Einstein, the tax system here in the United States is anything but easy to understand. But up until 1861 no in the United States paid income tax. In 1861 the government imposed new laws taxing the income of people to help pay for the Civil War efforts. During this time there was a 3% tax on all incomes over $800. Our tax system has vastly changed over the years and is still constantly evolving with the government thinking up new ways to collect taxes as well as new deductions and credits to reduce taxable income.
There are many different kinds of taxes including income tax, property tax, sales tax, state tax, taxes on imports, to name a few. For this article we are going to focus just on federal income tax. Federal income tax means we have to pay a portion of every paycheck or income to the government. All of these federal tax laws and regulations are enforced by the Internal Revenue Service (IRS) which is also responsible for collecting all of these taxes. The whole process of taxation and how to calculate the specific amount of tax owed will leave all but experts confused pretty quickly. There are seemingly endless factors that play into what our final tax bill will be at the end of the year.
We’re Very “Progressive”
Here in the United States our tax laws are referred to as a “progressive” tax system. And progressive doesn’t necessarily mean better and more advanced. Having a progressive tax system just means different portions of your income are taxed at different rates. Essentially, as you make more money you pay taxes at a higher and higher rate. So if you make very little money, it’s possible you might actually not have to pay any income tax at all. And if you make a lot of money, well, you pay a lot of it to the government. Our tax system is designed this way not to punish the wealthy, but because those who struggle with basic expenses like housing and food likely can’t afford to pay any money in the form of taxes to the government. That is how it is supposed to work, at least.
Understanding Income Tax Brackets
Most all of us have at least heard about tax brackets and maybe even overheard some conversations of people being in the 25% or 28% tax bracket for example. What does that even mean? I used to think that it meant I just had to look at a tax bracket table to figure out what tax bracket percentage I was in and then multiply that by how much money you made and BAM! I got the amount I’ll owed in taxes for the year, right? Well no, of course it couldn’t be that simple. Nothing with taxes ever is. Tax brackets only give us a very general idea of how much to pay in taxes. As I mentioned in the previous section, our tax system is progressive so your income is actually taxed at several different rates.
Our tax bracket system is a gradual tax schedule, which basically means as you make more money, you pay a higher tax rate. The amount of taxable income that you earn determines which tax bracket you fall into. But the higher tax rate does not apply to all of your income. It only applies on income earned beyond the previous tax bracket. While it is the goal of many taxpayers to keep their income in the lower tax bracket, remember that the gradual tax schedule ensures that not all of your income is taxed at a higher rate.
For 2017, there are seven income tax brackets based on different income levels. The tax rates in these seven brackets range from 10% all the way up to 39.6%. Here is a table that shows the percentages on the left with the corresponding income level as well as the tax filing status.
For example, if you are single and have $40,000 taxable income you move from the 15% tax bracket up to the 25% tax bracket. As mentioned earlier, at first glance you may think that all of your income is now going to be taxed at that higher rate. However, only the money that you earn within the 25% bracket range is taxed at the higher rate. I will have a few examples to explain in more detail later in the article.
Marginal Tax Rate vs. Effective Tax Rate
One of the more important things about taxes to understand is the difference between your marginal tax bracket and your effective tax rate. Your marginal tax rate is the highest bracket of taxes you pay. Your effective tax rate is how much you will actually pay compared to your taxable income. So if your income puts you in the 15% marginal tax bracket, you could potentially be paying an effective tax rate as low as 5%.
So why is your effective tax rate lower? Well, first of all, you aren’t taxed on your entire income. Your income can be reduced by different deductions and credits. Some of the most common types of deductions are mortgage interest and contributions to retirement accounts like 401(k)’s and IRA’s. What’s left after deductions and credits are taken is your taxable income, which is the amount your taxes will be applied to
Now let’s look at a few examples.
Let’s start with a pretty simple example. Say you are a single taxpayer with a taxable income (the amount after deductions and credits are taken) of just $9,000. As you can see from the chart, you are in the 10% tax bracket. So you owe 10% of your income to the government. To calculate 10% of $9,000 we just need to multiply $9,000 x 0.10 = $900.
Ok, that one was pretty easy. In this example your marginal and effective tax rate were both 10%. Let’s look at another more typical example.
Let’s say you are single and have a taxable income of $50,000. This puts you at the 25% marginal tax rate, but that doesn’t mean you are paying 25% of your taxable income, or $12,500, to the government.
Let’s go through the numbers to figure out how much you will owe for federal income tax and calculate your effective tax rate. Each chunk of your income that falls into a particular bracket is taxed at a different rate. The first $9,325 of your taxable income will be taxed at a 10% rate. The next portion of the taxable income you made from $9,325 to $37,950 will be taxed at a 15% rate. And the remaining portion of your taxable income above $37,950 will be taxed at a 25% rate. So we match the portions of your income to the corresponding tax rate, like this:
- 10% Portion : $9,325 x 10% = $932.50
- 15% Portion: ($37,950-$9,325) x 15% = $4,293.75
- 25% Portion: ($50,000-$37,950) x 25% = $3,012.50
- Total Tax Amount ($932.50 + $4,293.75 + $3,012.50) =$8,238.75
Then take the total tax amount and divide by the original taxable income to calculate the effective rate. In this case, the effective tax rate is $8,238.75 / $50,000 = 16.47%. That means that even though you are in the 25% tax bracket, you are only paying a little over 16% of your taxable income. We like that much better.
Let’s look at third example with a more typical income situation for couples. Let’s say a married couple and filing jointly and their combined taxable income is $105,000. Looking at the tax bracket table below let’s move over to the Married Filing Jointly column and with the $105,000 taxable income that puts the couple in the 25% tax bracket.
Let’s go through the numbers again to figure out how much this couple would owe for federal income tax and calculate the effective tax rate. Again, we need to match the portions of the income to the corresponding tax rate, like this:
- 10% Portion : $18,650 x 10% = $1,865
- 15% Portion: ($75,900-$18,650) x 15% = $8,587.50
- 25% Portion: ($105,000-$75,900) x 25% = $7,275
- Total Tax Amount ($1,865 + $8,587.50 + $7,275) = $17,727.50
Then take the total tax amount and divide by the original taxable income to calculate the effective rate. In this case, the effective tax rate is $17,727.50 / $105,000 = 16.88%. Again, while paying 16.88% of you income to taxes isn’t great, it is much better than 25%!
Don’t Be Afraid to Make More Money
Some people are afraid take advantage of opportunities for fear of entering into the next tax bracket. Yes, if you get a raise or get a side job your taxable income will likely go up and could even bump you up into a higher tax bracket. And yes, now being in a higher tax bracket will mean you will pay more in taxes, but remember the higher tax rate only applies to the money you’ve earned in excess of the previous tax bracket. Don’t turn down a raise or promotion because you’re afraid of a new tax bracket! It always makes sense to make more money!
It Could Always Be Worse
While is sucks to have to pay any taxes keep in mind that people in some countries pay much higher taxes. In Belgium and Germany many people, not just the wealthy, pay around 40% tax on the income they earned. While it may feel like our current U.S. tax system takes a ton of money from us, it is actually less than it has been in the past. Toward the end of World War II, specifically in 1944-45, there was a 94% tax bracket here in the United States. During this time anyone who had an income over $200,000 would have to pay 94% of that excess earning to the government in taxes. Granted $200,000 in 1944 is approximately equivalent to $2.4 million in today’s dollars with inflation. While it may be hard to feel sorry for someone making that much money it still has to be pretty crushing knowing that if you were successful and lucky enough to be making that much money that 94% of it would go to the government and you only got to keep 6% of the money you earned.
Recap of What to Know About Income Tax Brackets
- Your tax bracket is based on taxable income and filing status (such as Single or Married Filing Jointly)
- The highest percent of taxes you pay on the tax bracket table is your marginal tax rate
- Your tax bracket, or marginal tax rate, is not the same as your average or effective tax rate
- Your and most important takeaway is really just common sense – it always makes sense to make more money
Hopefully you learned a thing or two and now better understand the basics of income taxes and tax brackets. This was just the basics, and as Einstein alluded taxes only get more complicated and confusing from here.
What are some changes you would like to see to our current system? Would you be willing to pay more tax if you got free health care like in many other countries? Would you be willing to give up the guarantee of social security payments later in life if you could pay less taxes now? For some information on potential tax changes under Trump check out this article: What Does Trump Mean for Your Money?