This article will help you understand what is meant by “tax rate” and will alert you to some things that can significantly increase your tax rate.
There is much confusion surrounding the question, “what’s my tax rate?” The reason… Well that’s what we will explore here. Let’s start with the basics. The federal income tax is progressive, that doesn’t mean it is free thinking, though by the end of this piece you may think it is. Progressive means that as income increases so does the rate of tax. At this point the definition of “tax rate” splits into two separate ideas. First, effective tax rate: the total rate of tax paid on taxable income. Second, marginal tax rate: usually the rate of tax as calculated by applying your current tax bracket to your taxable income. The marginal tax rate is usually higher than the effective tax rate. So if you want to complain to your congressman about your taxes, use your marginal rate and not your effective rate. A quick example here should bring some clarity. Brody, a single taxpayer with taxable income of $89,000 has a marginal tax rate of 25%, but he is not paying $22,250 in tax because his effective rate is 20%. The effective rate is calculated as follows: The first $9,075 of income is taxed at 10%, the next $27,825 of income is taxed at 15%, and the remaining $52,100 of income is taxed at 25%. In the end he pays $18,106 in tax (9075 x .1 + 27825 x .15 + 52100 x .25 = 18106.25).
Usually when “tax rate” is referenced in the media or by a tax professional it is either the effective rate or marginal rate as described above. For the average person these rates may still be a bit unclear. One reason is that we use taxable income in the denominator when calculating the effective rate. Taxable income is a legal term, but in truth it has little relation to what most people consider to be their income. Let’s use the example above to illustrate this. I told you that Brody had taxable income of $89,000. What I didn’t tell you is that he earned a salary of $110,000. So why wasn’t his tax calculated on $110,000? Because the law allows Brody a number of deductions against his $110,000. He gets to deduct $3,950 just because he exists (called the personal exemption). He gets to deduct $6,200 as well, just because (called the standard deduction). In addition, Brody had to move for work and he contributed to an IRA. He was able to deduct the amount of his IRA contribution and the costs he incurred in moving which totaled $10,850. All together he reduced his salary of $110,000 by $21,000 before he calculated the tax he owed. But if he used $110,000 in the denominator when calculating his effective tax rate he would come up with only 16%, which is down 4% from the 20% stated earlier.
For those mathematicians or economists reading this, you have probably been pulling your hair out ever since I defined marginal tax rate above. Let me assure you that I understand the butchery. The real marginal tax rate is the rate of tax you would pay on the next dollar of income. This is difficult and time consuming to calculate even for a seasoned tax professional. Because of this, the shorthand marginal tax rate as discussed earlier is almost universally used. That being said, it can be very inaccurate. As you will see we are in desperate need of tax reform.
There are so many special tax deductions, credits, and preferred types of income that are subject to phase-out’s that the marginal tax rate on the next dollar of income swings wildly for some taxpayers. I will only provide one example because I want you to make it to the end of this article. Let’s change my original example just a bit. Brody is still single but he maintains a home for his daughter who is ten years old so he qualifies for the child tax credit. In addition he got a pay cut and only makes $99,850 per year. With these new facts Brody’s effective tax rate as commonly defined is 17.25% and his marginal tax rate as commonly defined is still 25%. In reality however his marginal tax rate is 5000%. That is correct; if Brody was to earn $1 more he would pay an additional $50 in tax. This is a result of the way that the child tax credit is phased out. Obviously very few people will fall exactly into this slot. However, there are many taxpayers out there who sit somewhere within the child tax credit phase-out range. For each child these taxpayers have their marginal tax rates will increase by a minimum of 5%. If there are 3 or 4 children the marginal tax rate can easily be 50%-100%.
The same kind of exorbitant marginal tax rates can hit owners of rental real estate, social security recipients, and those who claim the premium tax credit for health insurance they purchase through the exchange. Marginal rates can also be affected for those who itemize, are subject to the Medicare surtax, and so on.
We always encourage our clients to schedule regular tax planning where we can look at these and other possible tax traps and help guide you away from them.