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Why are Taxes Important?
The average single wage earner paid 29.6% of their pre-tax earnings in taxes in 2018.1 That is on average $17,596 every year! The area of taxes is grossly overlooked when thinking through personal finances. Often, the lack of knowledge, due to the extreme complexity, can be paralyzing to the point where the only solution feels like just pleading ignorance. I propose not ignoring the expense that represents roughly 30% of household income but educating yourself on the basics, so you can be sure to not leave Uncle Sam a tip on what is already an expensive bill every single year.
The tax law written by Congress is intended to incentivize certain behaviors (i.e. retirement savings, contributing to charities, home ownership, higher education, etc.) and disincentivize certain behaviors (i.e. tapping into retirement savings too early). Knowing the basics of the tax system can help you navigate these incentives to maximize your after-tax dollars.
Taxes are calculated by first categorizing income. Each category is treated differently, and some have much more favorable tax results than others. The “categories” are seemingly endless but the most common include:
- Earned Income (i.e. salaries and self-employed income)
- Qualified Investment Income (i.e. qualified dividends and long-term capital gains)
- Non-Qualified Investment Income (i.e. interest income and short-term capital gains)
- Passive Income (i.e. rents and business income in which you are a non-active investor)
Structuring your income streams for tax efficiency can have a meaningful impact on your personal bottom line and net worth.
Ordinary income tax rates are the most publicized because this is the rate that applies to your salary. Salaries are far and away the most common and largest source of household income. Below is a table of the 2019 ordinary income tax brackets or what I refer to as tax buckets.
2019 Federal Income Tax Brackets
Married Filing Joint
|Rate||Bottom of the Bucket||Top of the Bucket|
Tax brackets work like sequential buckets. You must fill up the first bucket before you move on to the second. The first $19,400 of taxable income for a married couple in 2019 is taxed at 10%. The first bucket of $19,400 is always taxed at 10% even if your total taxable income exceeds $19,400. Once you fill up this bucket with the first $19,400 of your income you then begin to fill up the 12% bucket with the next $59,550 ($78,950-$19,400) of your income. Everything in the second bucket is taxed at 12% regardless of your total taxable income. So, the first $19,400 in bucket #1 is being taxed at 10% and the next $59,550 in bucket #2 is taxed at 12% now you begin to fill bucket #3 and everything in bucket #3 is taxed at 22%. This process continues until you run out of taxable income.
Marginal Tax Rate
“What is my income tax rate?” Great question, there are two different measures of tax rates. Your marginal tax rate is the tax rate associated with the bucket you are currently, but not yet finished, filling up. So, if you have $100,000 of taxable income your marginal income tax rate is 22% because that is the bucket you have yet to completely fill up. In other words, if you earned an extra dollar of income, this is the tax rate on that extra dollar. Likewise, any tax deduction will save you taxes at your marginal rate. So, your taxable income is $100,000 and you are thinking of contributing $5,000 to a traditional IRA. Assuming you qualify for the tax deduction, this $5,000 would likely save you $1,100 ($5,000 x 22%). When you contribute to the traditional IRA you are taking some of the sand off the top of your bucket generating a tax savings at that bucket’s tax rate.
Effective Tax Rate
The effective tax rate is the rate at which you paid taxes when you are done filling up your buckets for the year. This rate is calculated by simply taking the taxes paid and dividing them by your taxable income. If your total income tax is $13,000 and your taxable income is $100,000, your effective tax rate is 13%. In a sense, this is your average tax rate. The average effective income tax rate for single workers in 2018 was 14.9% down 2.2% due to the Tax Cuts and Jobs Act.1
The above discussion only touched on ordinary income tax rates. To truly consider the taxes on your salary however, there is an additional set of taxes called payroll taxes. See Understanding Taxes: Earned Income for a dive into payroll taxes. For more on how your interest and dividends are taxed see Understanding Taxes: Investment Income.