Every industry has their own jargon; their own foreign language. Using everything from buzzwords and phrases like “dive deep” or “put a pin in it” to legalese like “prima facia” and “ipso facto,” professionals expect you to understand what they are talking about. The tax world is no different. Bifurcating the depreciation versus taking a Section 179 deduction are words that I use in everyday conversation, while the listener smiles and nods and hopes I will not go on and on about it for the next five minutes. Jargon is a pitfall of familiarity. To help you understand how progressive our tax system is, I present the following vocabulary lesson.
Taxable Income: The amount on income that is left AFTER you make all your adjustments and take out all your deductions. For example, a married couple with $100,000 in wages with no adjustments to income taking the standard deduction of $24,000; their taxable income is $76,000.
Tax Bracket: The highest rate of tax that you will pay on your taxable income; couple above would be in the 12% tax bracket
Effective Tax Rate: The ACTUAL percentage of tax that you pay on your income; Same couple pays 11% tax.
Progressive Tax System: Not a political thing, I promise! As you earn more money, you progressively pay more in tax. Everyone pays the exact same amount of tax at each level of taxable income; the difference is how much income you have.
According to 2017 tax return data, 96% of all individuals have an adjusted gross income (before deductions) of less than or equal to $200,000. 96%!! In the range of $200,000 to $500,000 is a mere 4%, while those individuals earning $500,000 to less than $10 million were only 0.87%.
I think it is safe to say that most of us fall into the under $500,000 range. Believe it or not, we all pay the same amount of tax on our earning at each level. Below is a depiction of how taxes are calculated in our progressive system. I am using Married Filing Jointly tax brackets and limits with different income levels.
| Married Filing Joint with Taxable Income of $77,400 | |
| First $19,050 taxed at 10% | $ 1,905.00 |
| Next $58,350 taxed at 12% | $ 7,002.00 |
| Total Tax Paid | $ 8,907.00 |
| Effective Tax Rate | 11% |
Married Filing Joint with Taxable Income of $175,000 | |
| First $19,050 taxed at 10% | $ 1,905.00 |
| Next $58,350 taxed at 12% | $ 7,002.00 |
| Next $87,600 taxed at 22% | $ 19,272.00 |
| Final $10,000 taxed at 24% | $ 2,400.00 |
| Total Tax Paid | $ 30,579.00 |
| Effective Tax Rate | 17% |
Married Filing Joint with Taxable Income of $400,000 | |
| First $19,050 taxed at 10% | $ 1,905.00 |
| Next $58,350 taxed at 12% | $ 7,002.00 |
| Next $87,600 taxed at 22% | $ 19,272.00 |
| Next $150,000 taxed at 24% | $ 36,000.00 |
| Final $85,000 taxed at 32% | $ 27,200.00 |
| Total Tax Paid | $ 91,379.00 |
| Effective Tax Rate | 23% |
This illustration shows how the tax rate progressively increases as your income climbs. However, your effective tax rate can be very different from your tax bracket. The next time someone tells you that they are in the 32% tax bracket, first congratulate them, then remind yourself that they are not paying a full one-third of their income to the government in taxes they are only paying about one quarter. In this case, the difference is the cost of a rather nice brand-new car.
There are other factors that have an impact on your effective tax rate, but I think I should stop here before your eyes glaze over.
My free advice this Friday – your income tax bracket does not define you, but your effective tax rate might. If you play your cards right, you can bring your tax rate down into the single digits. If you are interested in finding out more about your unique effective tax rate, you know where to find me!
Next week we’ll talk paycheck withholding; you might want to look at your check stubs!
~Amy
