# 3 Keys to Understanding our Tax System

November 19, 2021

# Taxes can be confusing. I'm here to clear up some of the confusion about how taxes work!

When discussing income tax rates or tax brackets, there are three very important terms to remember. They are Tax Bracket, Marginal Tax Rate, and Effective Tax Rate.

1. A Tax Bracket is a range of incomes taxed at a certain rate.
• The money you earn is divided into different brackets. I like to think of them as pockets. For a single person only \$9,875 can fit in the first pocket. You owe 10% on that pocket's money. Income you earn over \$9,875 goes in the second pocket. You owe 12% on that money. If you earn more than \$40,125, you'll need a third pocket. You owe 22% on that pocket's money...and so on. Please note: these incomes and percentages are listed in the 2020 tax rates table below.
2. Marginal Tax Rate is the percentage the highest dollar of income is taxed at.
• The highest percentage (most expensive) pocket (tax bracket) you have to put money in.
3. Effective Tax Rate is the average rate at which an individual's income is taxed. (ETR = Total tax ÷ Taxable income)
• This is your actual tax rate when you average the different percentages from your different pockets together.

When people say, "I'm in the 24% tax bracket, I make \$200k a year...," they refer to the Marginal Tax Rate. But their Effective Tax Rate may actually be closer to 18%.

How can this be? Our tax system is a progressive tax system. Just because the Marginal Tax Rate is 24% does not mean that every dollar of income is taxed at that rate. Each dollar is taxed in certain tiers.

Below are the 2020 tax rates from the IRS website:

• 37% for incomes over \$518,400 (\$622,050 for married couples filing jointly)
• 35% for incomes over \$207,350 (\$414,700 for married couples filing jointly)
• 32% for incomes over \$163,300 (\$326,600 for married couples filing jointly)
• 24% for incomes over \$85,525 (\$171,050 for married couples filing jointly)
• 22% for incomes over \$40,125 (\$80,250 for married couples filing jointly)
• 12% for incomes over \$9,875 (\$19,750 for married couples filing jointly)
• The lowest rate is 10% for incomes of \$9,875 or less for single filers (\$19,750 for married couples filing jointly)

To help explain, let's do a basic example using a married couple who earns \$200,000 a year. Please pay attention to the 2020 tax rates for married couples filing jointly listed above.

The first \$19,750 of this couple's income is taxed at 10% meaning that \$1,975 is due in tax.

Then, the amount \$19,751 through \$80,250 is taxed at 12%. The calculation to get the income in that range is \$80,250 - \$19,750 = \$60,500. \$60,500 of their income is taxed at 12%, meaning \$7,269 is due in tax. (\$60,500 x .12 = \$7,260)

Their income between \$80,251 and \$171,050 is taxed at 22%. \$171,050 - \$80,250 - \$90,800. \$90,800 is taxed at 22%, meaning \$19,976 is due in tax. (\$90,800 x .22 - \$19,976)

The next tax bracket is 24%. The remaining bit of this couple's income, \$28,950, ranging from \$171,051 to \$200,000 (their total income) is taxed at 24%, meaning \$6,948 is due in tax.

We calculate the total tax due by adding all the bolded numbers together. This couple needs to pay \$36,159 in taxes.

If all their \$200,000 income was taxed at 24%, they would owe \$48,000 in taxes. Because we use a progressive tax system in the United States, the actual tax due is \$36,159. This is \$11,841 less than the straight tax of 24%.

If you'd like to discuss your taxes with me, please give our office a call!