The Tax Bracket Fallacy

After “How do I avoid paying taxes?” The questions I get the most often is related to tax brackets and raises.  There is a common discrepancy between how tax brackets actually work and how many people believe they work.  Many people think that when your amount of your income moves into the next tax bracket all of your income is taxed in that next tax bracket.  Luckily, this is not true!  We will go through a short example to show the proper treatment of your income when you change tax brackets.  As I usually do we will look at an individual filing Married filing Jointly.

Even though we are looking at a married tax payer I am going to include the tax brackets for all filing statuses, so you can create your own example if you want.

 

Income Between
Tax Rate Individual Married Filing Jointly Married Filing Separately Head of Household Surviving Spouse
10% 0-$9,525 0-$19,050 0-$9,525 0-$13,600 0-$19,050
12% $9,526-$38,700 $19,051-$77,400 $9,526-$38,700 $13,601-$51,800 $19,051-$77,400
22% $38,701-$82,500 $77,401-$165,000 $38,701-$82,500 $51,801-$82,500 $77,401-$165,000
24% $82,501-$157,500 $165,001-$315,000 $82,501-$157,500 $82,501-$157,500 $165,001-$315,000
32% $157,501-$200,000 $315,001-$400,000 $157,501-$200,000 $157,501-$200,000 $315,001-$400,000
35% $200,001-$500,000 $400,001-$600,000 $200,001-$500,000 $200,001-$500,000 $400,001-$600,000
37% $500,000+ $600,000+ $500,000+ $500,001+ $600,000+

 

As you can see from the chart above if you are married filing jointly and your taxable income is $19,000, you are in the 10% tax bracket.  Ignoring any other taxes or credits your tax liability is $1,900.  Now, let’s say you get a raise and it increases your taxable income to $20,000.  Your income now puts you in the 12% tax bracket.  Those who believe the tax bracket fallacy would expect your tax liability to be $2,400 which is $20,000 multiplied by 12%.  This is not correct.  The calculation is slightly more complicated.  To calculate your tax liability, you now take $19,050 (the top of the first tax bracket) and multiply it by 10%, giving you $1,905.  Then you take your $20,000 taxable income and subtract the $19,050 ($950).  You then multiply the $950 and multiply it by 12% giving you $114.  Finally, you add the $1,905 and $114 together to get your correct tax liability of $2,019.  As you can see you have a saving of almost $400 by calculating your taxes correctly.

To drive the point home, we I will show one more example showing how you handle multiple tax brackets and give you a quick practice problem, so you can try for yourself.

In this example you are again married filing jointly, but this time your taxable income is $160,000.  As you can see you fall into the 24% tax bracket.  To calculate your tax liability, you multiply $19,050 (the top of the tax bracket) by 10% to get $1,905.  Then you take $77,400 (again the top of the tax bracket) and subtract $19,050 to get $58,350 and multiply it by 12% giving you $7002.  Now you subtract $77,400 (the top of the previous tax bracket) from $160,000 (your taxable income) to get $82,600.  Then you multiply that by 22% to get $18,172.  Finally, you add the three numbers you calculated together to get a tax liability of $27,079.  Again, to compare this to the calculation if you follow the tax bracket fallacy you would expect to have a liability of $35,200.

 

For the try on your own problem lets assume again that you are married filing jointly and your taxable income is $330,000.  Below I will provide the final answer.

 

Answer: $68,979

 

We would love to hear your feedback related to this post.  Was it helpful?  Were the concepts explained in a way that is easily understood?  Would you like more in-depth discussion?  Please let us know!

Items to know about the tax reform Part 3

In the first two installments of this series of posts we discussed the standard deduction and personal exemption changes implemented in the next tax plan. Where we left off in the second installment it seemed like the new plan is a bad deal for our example taxpayer. Today we will discuss the ways the taxpayer will come out ahead. We are going to discuss the changes in tax brackets and changes to the child tax credit.

In the first two installments of this series of posts we discussed the standard deduction and personal exemption changes implemented in the next tax plan. Where we left off in the second installment it seemed like the new plan is a bad deal for our example taxpayer. Today we will discuss the ways the taxpayer will come out ahead. We are going to discuss the changes in tax brackets and changes to the child tax credit.

Our example taxpayer sees a large benefit from the change in tax brackets and tax rates for 2018. As we discussed in the first two installments of this series of posts the taxable income increased in 2018 compared to 2017. The tax brackets are in the table below.

  Income Between   
Tax RateIndividualMarried Filing JointlyMarried Filing SeparatelyHead of HouseholdServing Spouse
10%0-$9,5250-$19,0500-$9,5250-$13,6000-$19,050
12%$9,526-$38,700$19,051-$77,400$9,526-$38,700$13,601-$51,800$19,051-$77,400
22%$38,701-$82,500$77,401-$165,000$38,701-$82,500$51,801-$82,500$77,401-$165,000
24%$82,501-$157,500$165,001-$315,000$82,501-$157,500$82,501-$157,500$165,001-$315,000
32%$157,501-$200,000$315,001-$400,000$157,501-$200,000$157,501-$200,000$315,001-$400,000
35%$200,001-$500,000$400,001-$600,000$200,001-$500,000$200,001-$500,000$400,001-$600,000
37%$500,000+$600,000+$500,000+$500,001+$600,000+

For our example taxpayer assuming the payer had two dependents the tax liability for 2017 was $9,733 and for 2018 it would be $8,739. As you can see our taxpayer saves approximately $1,000 less in 2018 compared to 2017.

The last item we will talk about today is the child tax credit. There were two changes made to the child tax credit. First, the credit doubled in the next tax plan. Increasing from $1,000 to $2,000 per child. Second, the amount of income you can have and still be eligible for the credit increased. The credit can be fully taken for those filing as married filing jointly and makeup to $400,000. So, for our example taxpayer when you factor in the child tax credit the amount of tax due in 2017 was $7,733 and in 2018 would be $4,739. This is an additional $2,000 savings, so in total the amount our example taxpayer saves in 2018 compared to 2017 is approximately $3,000.

We would love to hear your feedback related to this post. Was it helpful? Were the concepts explained in a way that is easily understood? Would you like more in-depth discussion? Please let us know!

Items to know about the tax reform Part 2

This is a follow up to the previous blog post regarding the changes to the standard deduction in the new tax code. If you haven’t already, I recommend you go back to that post and read it prior to this. In this post we are going to discuss the changes to the personal exemptions which will be relatively short. We will also discuss how this will affect your taxes when considered along with the changes in the standard deduction.

This is a follow up to the previous blog post regarding the changes to the standard deduction in the new tax code. If you haven’t already, I recommend you go back to that post and read it prior to this. In this post we are going to discuss the changes to the personal exemptions which will be relatively short. We will also discuss how this will affect your taxes when considered along with the changes in the standard deduction.

The short story is the personal exemptions were eliminated in the new tax bill. Now that we have that out of the way it will be helpful to back up a step and explain what the personal exemptions were to explain the impact they will have on your taxes. Personal exemptions worked like the standard deduction. There were two main differences, first is the amount of the personal exemption is the same for everyone ($4,050 in 2017). Second, you receive an exemption for each person associate with the tax return (the taxpayer, spouse if filing jointly, and any eligible dependents). Most people are familiar with this when they would fill out their W-4 form at work that determines how much will be withheld from your paycheck for taxes. So, if you are married filing jointly and have 2 eligible dependents in 2017 your total deduction for personal exemptions would have been $16,100.
To illustrate the affect this has on your taxes we need to look at this change with the change in standard deductions. Let’s look at the table below that provides a comparison of your 2017 taxable income versus your 2018 taxable income. This table assumes the taxpayer is filing married filing jointly.

 2017  2018
Number of Exemptions2340
Income $ 100,000 $ 100,000 $ 100,000 $ 100,000
Itemized/Standard Deduction $ 12,700 $ 12,700 $ 12,700 $ 24,000
Personal Exemptions $ 8,100 $ 12,150 $ 16,200 $ -
Taxable Income$ 79,200 $ 75,150 $ 71,100 $ 76,000

As you can see from this table, if you have two exemptions which is the minimum you can have for a married filing jointly return then you come out slightly ahead in 2018 compared to 2017. However, if you have any dependents at all, then you will have a higher taxable income in 2018 than you did last year.

So far, this new tax plan seems like a bad deal for our example taxpayer. However, there are other items that are going to help the taxpayer out and likely reduce the amount of tax that is due in 2018. We will talk about more of those in the next installment.

We would love to hear your feedback related to this post. Was it helpful? Were the concepts explained in a way that is easily understood? Would you like more in-depth discussion? Please let us know!