Summary
Do you feel like you're paying too much in taxes? Chances are you're paying less than you think. Here's the common misconception when it comes to paying the taxes in your tax bracket.
When asked what your tax bracket is you probably just say a number like 22% or 24% assuming you know what it is and are comfortable telling that person. It's not quite that simple though. As a single person, if you make $100,000 a year that will put you in the 24% tax bracket meaning you pay $24,000 in taxes, right? Wrong! That may feel about right when it hits your bank account but you have other deductions if you're employed like medical benefits, retirement contributions, plus any other number of things outside of work-sponsored benefits depending on your situation. If you paid that much in taxes in addition to these deductions you'd be living a much different lifestyle and I'll show you why in a moment. This is what's known as your marginal tax rate. What that means is you take your total taxable income this year, compare it to a tax chart, and the income range you land in is your marginal tax rate. Let's go through a fictitious example to better explain how it works. For simplicity sake, let's just assume there's nothing else in your life that will effect your income from a tax standpoint and pretend the tax brackets were as follows for ease of math:
| Tax Rate | Your Annual Income |
|---|---|
| 5% | $0 - $20,000 |
| 10% | $20,000 - $50,000 |
| 20% | $50,000 - $100,000 |
Let's assume your salary is $70,000 this year which puts you in the 20% bracket. But how it works is different than you may think. You don't pay 20% on the total $70,000. You only pay that rate for your earnings inside each bracket. In this case you earned $20,000 into the 20% bracket so you only pay 20% on that $20,000. That comes out to $4,000 which is monumentally different than paying it on the full $70,000. If we work our way up the table doing the same thing for the 10% bracket, you earned the full $30,000 there so you pay $3,000 in taxes on those earnings. For the lowest bracket you pay 5% on the full $20,000 you earned there which is $1,000. If we add that all up your total taxes paid is $8,000 versus the $14,000 ($70,000 x 20%) you probably thought you're paying.
| Tax Rate | Your Annual Income | Taxes You Pay |
|---|---|---|
| 5% | $0 - $20,000 | 5% * $20,000 =$1,000 |
| 10% | $20,000 - $50,000 | 10% * $30,000 = $3,000 |
| 20% | $50,000 - $70,000 | 20% * $20,000 = $4,000 |
| Total Taxes Paid = $8,000 |
Now, if we take this $8,000, the amount of taxes you actually paid, divide that by your income ($8,000 / $70,000), you get ~11.4%. This is called your effective tax rate which is 8.6% lower than your 20% marginal tax rate.
Now, whether this makes you feel better about the taxes you're paying I can't say. I do hope this gives you a better understanding of how paying your taxes work. You can view the current tax brackets here along with other tax information or go to the menu above under Taxes to find Tax Facts. This is not the end of the story by any means because there are many other factors that play into the taxes you do and don't pay such as write-offs from mortgage interest, charitable donations, having dependents, deductions from retirement account contributions, etc. Some of this and more I'll cover in future posts but I'm not a CPA so the majority of information when it comes to filing your taxes I'll leave to the very capable folks who are better educated to do so.