In January someone told me that most people have broken their New Year's resolutions by the end of February. Armed with that trivia and the knowledge that my resolution to post to this blog once a week wasn't broken until April provides no solace. I "owe" you guys a couple of posts and will be posting some extra ones soon.
Everyone knows tax day was yesterday, April 15th, so it seems appropriate that we discuss an often misunderstood element of taxes and financial planning – tax brackets.
Our tax system is a progressive tax. That means that you pay an increasing percentage of your income as taxes as your income increases. But moving up to a new tax bracket only affects the additional dollars you have earned. It does not increase your tax liability on all your income1. For example, let's study the 2008 Married Filing Jointly tax brackets.
|
Taxable Income Over… |
But Less Than… |
The Tax Is… |
Of the Amount Over… |
|
$0 |
$16,500 |
$0 + 10% |
$0 |
|
$16,050 |
$65,100 |
$1,605 + 15% |
$16,050 |
|
$65,100 |
$131,450 |
$8,962.50 + 25% |
$65,100 |
|
$131,450 |
$200,300 |
$25,550 + 33% |
$131,450 |
|
$200,300 |
$357,700 |
$44,828 + 33% |
$200,300 |
|
$357,700 |
And Over |
$96,770 + 35% |
$357,700 |
So how do you read this chart?
Start with your taxable income or the amount of income you are actually taxed on after taking all your legal deductions and exemptions. Chances are you earn much more than your taxable income. For example, let us examine a married couple. He is self employed and has gross earnings of $105,604 and his wife is a W-2 employee with gross earnings (after pre-tax deductions like 401(k) and health insurance) of $49,228. Their banker saw $154,832 flow through their checking account but after business expenses and self employed retirement savings they are able to reduce their adjusted gross income (AGI) down to $112,705. Their taxable income is even lower at $70,241 which is found by starting with their AGI and subtracting itemized deductions and personal exemption amounts.
Now we can look at the chart. The taxable income is over $65,100 and less than $131,450 so we use the third line. The total tax due is $10,247.75 which and this it is calculated $8,962.50 + 25% of ($70,241 - $65,100). In other words, they are pay 25% only on the amount over $65,100.
What tax bracket is this couple in? The third line down is the 25% bracket, but they paid nothing close to $38,708 which is 25% of $154,832 which is why we must distinguish between marginal and effective tax rates.
Marginal tax rate is the amount of tax you would pay on the next dollar you earn. For this couple that is 25%.
Effective tax rate is the percentage of taxable income actually paid in taxes. This couple has an effective tax rate of 14.6%.
In financial planning, we most often use marginal tax rates. Financial planners think "if my client had an opportunity to increase their income by $1000, they would owe $250 in additional taxes and would net $750", but when you file your tax return, effective tax rates are the most accurate measurement of your tax liability.
AIC does not give legal or tax advice. For specific information applying a strategy consult your attorney or tax professional.
1 An increase in adjusted gross income can increase your tax liability by disqualifying various deductions and credits.
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