I came close. So close. Like ... this close to not writing this subject column, at the risk of it being a yawn, yawn and Yaaaaaawwwwwwn … for far too many people. So, don’t feel bad if you don’t find this narrative as thrilling as I do! In fact, I won’t be offended if you just take a deep breath and turn the page to perhaps something more to your liking.
OK, enough of the chit chat … away we go. We (United States) have what is referred to as a progressive tax system, which means folks with higher taxable incomes pay higher federal income tax rates. However, being “in” a tax bracket does not mean one pays federal income at that rate on all of their taxable income.
I like the way that the informative website, www.nerdwallet.com, explains it; “The government decides how much tax you owe by dividing your taxable income into chunks — also known as tax brackets — and each chunk gets taxed at the corresponding tax rate. The beauty of this is that no matter which bracket you’re in, you won’t pay that tax rate on your entire income.”
You got it? In other words, one could be “in” say a 24% tax bracket but his or her “effective” tax rate will always be lower. I will give you an example that should add clarity to the issue in question, but first take a moment to review the 2021 marginal tax brackets below for an unmarried individual and married individuals filing a joint return.
Rate For Unmarried Individuals Filing Joint Returns for Married Individuals
10% Up to $9,950 Up to $19,900
12% $9,951 to $40,525 $19,901 to $81,050
22% $40,526 to $86,375 $81,051 to $172,750
24% $86,376 to $164,925 $172,751 to $329,850
32% $164,926 to $209,425 $329,851 to $418,850
35% $209,426 to $523,600 $418,851 to $628,300
37% Over $523,600 Over $628,300
Example: Let’s say you are a single filer with $32,000 in taxable income. Please keep in mind that the $32,000 is the “taxable” income, which is your income after you apply your standard deduction (see below) or if you itemize, after your itemized deductions.
2021 Standard Deduction
Filing Status Deduction Amount
Single $12,550
Married Filing Jointly $25,100
Head of Household $18,800
Source: nerdwallet.com, IRS
OK, back to the example … the $32,000 puts you in the 12% tax bracket (see above brackets). To see if you are paying attention allow me to ask you a question …
would you pay 12% on all of your $32,000? If you said, nope, and it was not a guess, kudos to you student! You are correct if you are thinking that you would pay 10% on your first $9,995 (see above brackets) and then you would pay 12% on the rest. Therefore, you might be “in” the 12% marginal tax bracket, but your “average” or “effective” tax rate is 11.36%. Confused? Don’t be, as it is rather simple math to get to the 11.36% rate.
Here is how the math works … 10% of $9,995 = $995 + 12% of 22,005 (which is the additional amount to get to $32,000) = $2,640. So, your tax amount due is $995 + $2,640 or $3,635. To determine what the average rate is, you would simply divide your tax amount, which is $3,636 by $32,000, which is your taxable income (your taxable income). That my friends is how you get to 11.36% effective tax rate on $32,000 of taxable income. Once again, you’re in the 12% marginal tax bracket but your effective tax rate is lower at 11.36%.
If you need time to unpretzel your brain, now would be great, as the teacher is going home!
Harry Pappas Jr. CFP®
Managing Director-Investments
Master of Science Degree Personal Financial Planning
Certified Estate & Trust Specialist ™
Certified Divorce Financial Analyst™
Pappas Wealth Management Group of Wells Fargo Advisors
818 North Highway A1A, Ste. 200
Ponte Vedra, Florida 32082
904-273-7955
harry.pappas@wellsfargoadvisors.com
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