Let’s talk taxes. It seems like this is a HUGE subject this election cycle but I feel like people don’t know a whole lot about it. First, let’s discuss how taxes are set. Congress votes on taxes. Which means that the President, no matter who he or she is, can only decide to veto the legislation. So, when a President says they want to raise or lower taxes, what they are really doing is advising Congress on what they think would be a good idea.
Now, how do we calculate taxes? I keep seeing people focus on the marginal tax rate, instead of the effective tax rate. What’s the difference? Basically, your marginal tax rate is the tax rate that will apply to your next marginal – or incremental – amount of income, and your effective tax rate is simply your total tax burden, divided by your total income.
When you see a tax bracket, what you’re seeing are marginal tax rates . But, the way taxes are calculated isn’t as simple as that. Instead, you’re taxed in each bracket up to the one that is your highest. Let me give you an example:
Let’s say you’re single and earn $100,000 this year. To calculate your taxes we’d start with $9,225 at 10%, which gives us $922.50 . Next, we subtract $9,226 from $37,450 which is $28,224 and tax that at 15% ($4,233.60), since you’d be completely in the next two brackets. On to the next bracket, $90,750 minus $37,451 is $53,299 at 25% ($13,324.75) . And now the final bracket, $100,000 minus $90,751 which gives us $9,249 at 28% for the final $2,589.72 . Now we add those calculations:
$922.50 + $4,233.60 + $13,324.75 + $2,589.72 giving us a total tax burden before any exemptions of $21,070.57 .
Now, let’s divide that $21,070.57 into your total income of $100,000 and you get 21%.
As you can see, your marginal tax rate was 28% (where your income of $100,000 fell on the rate table) but your effective tax rate was 21%, before exemptions. Remember that your effective tax rate should still be lower once deductions and exemptions are factored in.
Where does this leave us? We discussed how taxes are decided, and we discussed the difference between marginal tax rate (the tax rate that your earnings put you in) and effective tax rate (the rate that you actually pay). As a final example, without including specifics, I just completed our 2015 taxes, filing jointly with my wife, and we’re just barely in the 25% tax bracket. After everything our effective tax rate is 9.6%! That’s a HUGE difference but, I’m still going to have a professional check to make sure I didn’t miss anything.
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