Novel Investor

Compounding investing wisdom...

  • Home
  • About
  • Library
  • Quotes
  • Resources

How Tax Brackets Work

June 14, 2019 by Jon

Tax BracketsYou can’t go through tax season or file your taxes without knowing how tax brackets work. The U.S. has a progressive tax system that does one thing well, it tells you the tax bracket you fall into, but it doesn’t tell you the whole story.

While someone may sit in the 25% federal tax bracket, that doesn’t mean they actually pay that much in taxes. In fact, they pay less than 25% in taxes because of how the tax system works. Let me explain.

Marginal Vs. Effective

The tax bracket you fall into is your marginal tax rate. The marginal tax rate represents the tax you pay on the last dollar you earn. But it’s not the tax rate you pay on every dollar you earn.

To find the tax rate you pay on your total taxable income, you need to find the average tax rate, called your effective tax rate. To do that, you need a bit of math.

How It Works

The best way to explain it is with an example. I’ll be using the 2012 federal tax brackets for a single person as a reference. For this example, assume this single person, let’s call her Sue, has a taxable income of $500,000. Sue’s income is far above average (because I wouldn’t be able to use the entire table below that I labored over for hours).

Here’s how her income is taxed:

Tax Rate Single Income Break Down Taxes on $500,000 in Taxable Income
10% $0 – $8,700 The first $8,700 10% of $8,700 or $870
15% $8,700 – $35,350 The next $26,650 $870 plus 15% of $26,650 or $4,867.50
25% $35,350 – $85,650 The next $50,300 $4,867.50 plus 25% of $50,300 or $17,442.50
28% $85,650 – $178,650 The next $93,000 $17,442.50 plus 28% of $93,000 or $43,482.50
33% $178,650 – $388,350 The next $209,700 $43,482.50 plus 33% of $209,700 or $112,683.50
35% Over $388,350 Amount over $388,350 $112,683.50 plus 35% of $111,650 totaling $151,761.00 in income tax!

As you see from the table, Sue is only taxed on the amount of income that falls into each tax bracket.

For a single person making $500,000, the first $8,700 is taxed at the 10% tax rate, then the next $26,650 ($35,350 – $8,700) is taxed at the 15% tax rate. The next $50,300 is taxed at 25% and so on as the last column shows.

That gives Sue a total of $151,761 in income taxes. You can divide that total by the taxable income ($151,761/$500,000) to get an effective tax rate of about 30%. Even though Sue falls into the 35% tax bracket, she only pays about 30% of her income in taxes (it’s actually lower once you figure in tax deductions and credits).

For another example let’s use a more realistic $35,350 in taxable income. This person pays 10% in taxes on the first $8,700, then pays 15% on the remaining $26,650. This brings the total to $4,867.50 in taxes or an effective tax rate just under 14%. If that same person made just $1 more, moving them into the 25% tax bracket, only the $1 would be taxed at 25%, which amounts to 25 cents more in taxes.

So What Does All This Mean?

First, you should still try to lower your taxes as much as legally possible with tax credits and deductions.

Second, put as much money as you can into retirement accounts to lower your taxable income further. There are several tools available that make this easy. I use TurboTax for tax planning and TD Ameritrade for my IRA. There are several other brokers with no fee IRAs too.

Last, don’t be afraid to earn more money and fall into a higher marginal tax rate. You will always pay more taxes as your income increases. But, when your income increases, your after-tax income will always increase too.

Print Friendly, PDF & Email

Sign up for more weekly wisdom.

Want to compound your investing wisdom?

Find Out More

Learning

  • Library
  • Book Notes
  • Quotes

Return Tables

  • Asset Class Returns
  • Stock Sector Returns
  • International Stock Market Returns
  • Emerging Markets Returns
  • Historical Returns

Connect

Search

  • Home
  • About
  • Contact

© 2023 Novel Investor · All Rights Reserved · Terms of Use · Privacy Policy · Disclaimer