Understanding Your Tax Bracket vs. Effective Tax Rate

Did you know that if you are in the 25% tax bracket you do not pay 25% tax on your income?

Think about this for a second.  In 2016 a married couple who made $75,300 would be in the 15% tax bracket.  That would mean you would owe taxes of $11,295 ($75,900 X .15).

But, if you made $1 more in the year or $75,301, you would jump up to the 25% tax bracket.  That would mean you would owe taxes of $18,825 ($75,901 X .25).

You would keep $64,005 if you made $75,300.

But you would only keep $56,475 if you made $1 more.

If our tax system worked this way there would be no incentive to work harder and make more money?

I’ve had conversations with officers who didn’t want to work more overtime because it would put them in a higher tax bracket.  Luckily this is not how our tax system works.

Your Tax Bracket vs. Effective Tax Rate

The simple way to explain this is that your income that falls in the 10% tax bracket is always taxed at 10%.  If you make money above the 10% bracket, only the money above is taxed at the next bracket of 15%.  Again, if you make money above the 15% tax bracket, only the money above is taxed at 25%.  It continues on from there.  Currently we also have tax brackets of 28%, 33%, 35% and 39.6%.

To explain this I will go through two examples; one for a single person and one for a married couple.  If you are single keep reading and if you are married go ahead and skip to the next example.

How Taxes Work For A Single Person Who Makes $80,000 of Taxable Income In 2016

The first $9,275 is taxed at 10% or $927.50

The next $28,375 is taxed at 15% or $4,256.25

The next $42,350 is taxed at 25% or $10,587.50

If you add up those chunks of income it equals your total of $80,000 income ($9,275 + $28,375 + $42,350)

The total taxes you pay is $15,771.25 ($927.50 + $4,256.25 + $10,587.50)

This means you actually paid 19.71% in taxes ($15,771.25 / $80,000) not 25%.

25% is called your Tax Bracket.

19.71% is your Effective Tax Rate

How Taxes Work For A Married Couple Who Makes $80,000 of Taxable Income In 2016

The first $18,550 is taxed at 10% or $1,855

The next $56,750 is taxed at 15% or $8,512.50

The next $4,700 is taxed at 25% or $1,175

If you add up those chunks of income it equals your total of $80,000 income ($18,550 + $56,750 + $4,700)

The total taxes you pay is $11,542.50 ($1,855 + $8,512.50 + $1,175)

This means you actually paid 14.43% in taxes ($11,542.50 / $80,000) not 25%.

25% is called your Tax Bracket.

14.43% is your Effective Tax Rate

Why Does A Married Couple Pay Less Tax?

Keep in mind, in these two examples the amount of income stayed the same, at $80,000.  This assumes that a married couple has only one person working and the other stays home with the children.  For this reason a married couple gets a tax break since, one person is working to feed another adult and possibly multiple children.

This is where the Marriage Penalty comes into play.

Remember, if two single people made $80,000 (or $160,000) they would each pay tax of $15,771.25 (or $31,542.50).

However a married couple making $160,000 would look like this:

The first $18,550 is taxed at 10% or $1,855

The next $56,750 is taxed at 15% or $8,512.50

The next $76,600 is taxed at 25% or $19,150

The next $8,100 is taxed at 28% or $2,268

If you add up those chunks of income it equals your total of $160,000 income ($18,550 + $56,750 + $76,600 + $8,100)

The total taxes you pay is $31,785.50 ($1,855 + $8,512.50 + $19,150 + $2,268)

This means you actually paid 19.87% in taxes ($31,785.50 / $160,000) not 28%.

28% is called your Tax Bracket.

19.87% is your Effective Tax Rate

In other words, two single people, each making $80,000 would have an Effective Tax Rate of 19.71%.  A married couple with each person making $80,000 would have an Effective Tax Rate of 19.87%.

This is not a big difference but the point is when both people in a marriage are working you can be pushed into a higher tax bracket and pay more taxes.

To see what the tax brackets are just Google “2016 Tax Brackets” and click onto the link to the IRS.

To see what your marginal tax rate is, look at your last tax return and divide how much you paid in tax by your taxable income.  This is found on form 1040.  Divide line 44 by line 43.

Gross Income vs. Taxable Income

Gross Income is simply your hourly rate multiplied by all the hours you worked, but remember you don’t take home all of that money.  Some is taken out for health insurance, dental insurance, deferred compensation, pension, etc.  These are all taken out of your Gross Income and the result is what you are taxed on or your Taxable Income.

There are many tricks to reduce your Taxable Income and thus reduce your tax bill.  We’ll go over this in more detail later.

PSPRS Refund Taxes

Remember, your PSPRS refund is treated as Taxable Income.  As you saw above when you add your refund on top of your Taxable Income you could be pushed into the next, higher tax bracket.

This is why it is so important to manage your Taxable Income and reduce it to pay less tax.

In Summary

The main lessons to learn here are:

  1. Taxes are calculated based on the bracket your income falls in. If you make more money only the additional amount is taxed at the higher rate.
  2. A married couple gets a tax benefit if only one member of the family is working.  If both are working you may pay more.
  3. A big bonus or PSPRS Refund can push you into a higher tax bracket if you don’t manage your Taxable Income.
  4. Stay tuned for an explanation of how to read your paycheck to differentiate your Gross Income vs. your Taxable Income.  From here you will learn how to reduce your Taxable Income.

If any of this was unclear please let me know so I can try to explain it better.  I plan to make videos in the future to give a more visual explanation of how taxes work.

Leave a Reply

Your email address will not be published. Required fields are marked *