Do you know what your tax rate is?
That’s a trick question as you really have two tax
rates: 1) your Marginal Tax Rate and 2) your Effective Tax Rate.
To understand each, you need to understand our tax system. The U.S. tax
system is not based on a single tax
rate, but rather a series of tax rates known as tax brackets based on your amount of taxable
income. Everyone pays the same tax rates at each income level, and the more
taxable income you have, the higher your tax rate.
The premise behind this tax system is that those with a higher ability to
pay (higher income) carry a greater tax burden than those with a lower ability
to pay (lower income).
Now
let’s take a look below at the 2013 tax brackets for someone filing as “Married
Filing Jointly.” (This is referred to as your tax filing status. We won’t go
into detail here as this can be an entirely separate topic.)
Taxable Income
|
Tax Rate
|
Under $17,850
|
10%
|
$17,850 – $72,500
|
15%
|
$72,500 – $146,400
|
25%
|
$146,400 – $223,050
|
28%
|
$223,050 – $398,350
|
33%
|
$398,350 – $450,000
|
35%
|
Over $450,000
|
39.6%
|
In our hypothetical example, Calvin and Grace Coolidge are
Married Filing Jointly with a taxable income of $150,000.
Based on the chart above, their taxable income puts them
just in the 28% tax bracket (shaded). This is their Marginal Tax Rate. In other words, if
Calvin was given a raise of $1, this additional $1 of income would be taxed at
28%. (He would pay 28¢ in taxes and keep 72¢ in income.)
While their Marginal
Tax Rate is 28%, not all of their
taxable income is taxed at 28%. Here’s how their tax brackets would be
calculated.
For the taxable income over …
|
But not more than …
|
The tax rate is
…
|
And the tax is …
|
Income taxed at this rate …
|
$0
|
$17,850.00
|
+ 10%
|
$1,785.00
|
$17,850.00
|
$17,850.01
|
$72,500.00
|
+ 15%
|
$8,197.50
|
$54,650.00
|
$72,500.01
|
$146,400.00
|
+ 25%
|
$18,475.00
|
$73,900.00
|
$146,400.01
|
$223,050.00
|
+ 28%
|
$1,088.00
|
$3,600.00
|
Totals
|
$29,465.50
|
$150,000.00
|
So in the example above, Calvin and Grace paid a total of $29,465.50
in taxes on taxable income of $150,000. If we divide the total taxes paid by
the total taxable income we get 19.64% (25,662.50/150,000.00 = 0.1964 or 19.64%).
This is their Effective Tax Rate.
In other words, if they paid flat tax
rates on all of their taxable
income, it would have equaled 19.64%.
In our example, the couple has a Marginal Tax Rate of 28% and an Effective Tax Rate of 19.64%. This tells us that any
additional income would be taxed at a minimum of 28%, and that overall they are
paying tax of 19.64% on all their income.
If you have more questions about either your Effective Tax Rate1 or Marginal Tax Rate2, or how they impact your financial decisions, please feel
free to contact our office.
Let’s take our hypothetical example one step further. Assume
that Calvin and Grace took advantage of every credit, exemption and deduction
allowable and arrived at the taxable income of $150,000.00 noted above. Then
their tax liability would be $29,465.50 and they can do nothing to change that.
Whether they get a tax
refund or make a tax payment
depends only on if they had too much or too little in taxes withheld from their
income. If, for example, they had $31,000.00 withheld, then when they file
their 2013 taxes they will be entitled to a refund of $1,534.50 (31,000.00 – 29,465.50
= 1,554.50). If, however, they only had $28,000.00 withheld, then when they
file their 2013 taxes they will owe $1,465.50 (28,000.00 – 29,465.50 = -1,465.50).
The key, then, to tax planning is to understand these
concepts and to maximize every credit, exemption and deduction allowable. At
Kemp & Associates, tax planning is included in all of our financial
planning. For more information on how we can help you plan for
retirement, contact us today.
1 "Effective Tax Rate Calculation" eHow Money,
December 3, 2012; http://www.ehow.com/way_5202142_effective-tax-rate-calculation.html
2 "Update: 2013 Federal Income Tax Brackets and Marginal
Rates" Forbes, January5, 2013; http://www.forbes.com/sites/moneybuilder/2013/01/05/updated-2013-federal-income-tax-brackets-and-marginal-rates/
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