Dispelling the Tax Bracket Misconception
It's April 21st, 2014, and tax preparation professionals everywhere are breathing a sigh of relief as the data-intensive, document-laden official tax filing season has come and gone. Whew!
We've crunched the numbers, sifted through countless W-2's, 1099's, P&L's, receipts, and have once again been reminded of our appreciation for organization and great software. It's been a fresh year for tax law, with a few of the American Taxpayer Relief Act of 2012 tax breaks expiring (e.g. Pease limitation on itemized deductions, Personal Exemption Phaseout), and the addition of a few new provisions. Many have had the opportunity (whether desired or not) to see these new tax provisions in action, such as the Additional Medicare Tax and Net Investment Income Tax affecting higher income earners for 2013 (Single: modified AGI $200,000+, Married Filing Jointly: modified AGI $250,000+.) We've also seen the first year that the IRS has acknowledged same-sex marriages for federal tax filing purposes (if the marriage was registered in a state that has legalized same-sex marriage, regardless of domicility.) With all the change abound, though, one classic misconception (tax myth, if you will), has proven its innate survival instinct for yet another year: The Marginal Income Tax Bracket Misconception. Many folks still believe that if they're in the 28% marginal income tax bracket, that they're paying a flat 28% tax on their total income. The truth is, they're only paying that 28% tax rate on the top portion of their taxable income -- they're paying 10% on the first portion, 15% on the next bit, 25% on the next, then the 28% on the last bit. Marginal tax bracket means that any additional income earned within the bracket's range will be taxed at the bracket's rate, as the table below illustrates. (Source: http://www.bankrate.com/finance/taxes/tax-brackets.aspx)
A true representation of a person's tax liability is their effective income tax rate. The effective income tax rate is calculated by taking the sum of the tax due for all marginal income tax brackets and dividing it by a taxpayer's taxable income. For example: John Smith, a single taxpayer, earns total wages of $105,000 reported to him on his W-2 for 2014. Assuming this is John's only income, he'll take the 2014 standard deduction of $6,200 and a personal exemption of $3,950 to compute his taxable income of $94,850. Using the table above, that taxable income puts John in the 28% marginal tax bracket. However, we can calculate his effective tax rate by determining the amount of tax he pays in each bracket: Tax Bracket Tax Due 10% .10*9,075 = $907.50 15% .15*(36,900-9,075) = $4,173.75 25% .25*(89,350-36,900) = $13,112.50 28% .28*(94,850-89,350) = $1,540.00 Total Tax Liability = $19,733.75 Effective Tax Rate = (19,733.75/94,850.00) = 20.8% As the math shows, John's effective tax rate is 20.8%. This is the average tax rate he pays on his taxable income, through those several marginal tax brackets. He actually pays the most tax in the 25% bracket, as the majority of his taxable income falls within that bracket. This simple exercise can help illustrate the true effect of common tax strategies, deductions, and credits available to taxpayers, such as the student loan interest deduction and IRA contribution deduction. It's important to know if you qualify for these different deductions and credits, and how they can affect your personal tax situation. Always consult your trusted tax professional and financial advisor when navigating these types of scenarios.