Welcome to the internet. If you’ve spent enough time poking around, you know that there are a lot of people on the internet that don’t understand taxes, especially the differences between tax rates and tax brackets. Here’s a quick explanation of the basics.
First, you calculate your tax rate after all of the numbers are known. So, if you look back at 2016 and find out that you made $100,000 dollars exactly and you paid $35,000 in taxes on that, you have a tax rate of 35%. This is the simplest number to calculate, and sometimes you can guess that your tax rate at the end of this year will be similar to your tax rate last year.
Americans pay a lot of different federal income tax rates. Some people could pay as much as 39% and some people can arrange their finances to pay as little as 16% income tax rate.
However, you can’t just multiply your yearly income by 35% to figure out how much money you owe for taxes. The actual calculation there is much more complex and is based on tax brackets, as well as many other factors.
First, there’s a pair of things called the Standard Deduction and the Personal Exemption. For a single person in 2016, combined they are $10,350. That means that a single person with no kids in the United States pays no federal income taxes on their first $10,350 dollars of income. A person that makes only $5,000 dollars a year doesn’t pay federal income taxes (but there are a lot of other taxes that they pay, in other categories).
There are plenty of other things that affect how much of your income is taxable. The US government allows people to subtract things like tuition, alimony, student loan interest, and some kinds of social security income from their taxable income. There are also some kinds of income that are taxed at special rates (generally the one that people care about is capital gains, which we won’t address in this article).
But alright, you’ve figured out how much of your income is taxable and now there are tax brackets to look at. The first tax bracket in the United States is actually 10%, and it applies to the first $9,275 of taxable income that our hypothetical single person with no kids makes. So for this bracket, if their taxable income is more than $9,275 they still only pay 10% of that, $928 dollars (rounding up to the nearest dollar here), on these first $9,275.
The second tax bracket is 15% and it applies to income between $9,276 and $37,650. You’ll notice that it starts after the first bracket of 10%, so you only pay 15% on dollars that you make after $9,275. If your taxable income is $15,275 you add the $928 from the 10% you paid on the first $9,275 to the 15% of the additional $6,000 that is in the second bracket. In this case, that’s $900, for a total of $1,828 in taxes.
The way that people describe their tax brackets is by talking about the percentage on the last dollar that they make, so if someone with a taxable income of $15,275 tells you what their tax bracket is, they will tell you that it’s 15%. But remember, the tax rate also includes the Standard Deduction & Personal Exemption of $10,400 and so the original income would be $25,275. If you figure it out, the taxes of $1,828 on an income of $25,275 is a tax rate of 7%
That’s right, their tax bracket is 15%, but their tax rate is 7%, which is less than half of that.
There are seven tax brackets in the United States, and the highest one is 39.6% and it only applies to taxable income more than $415,051 in a year. That’s absolute highest income tax bracket that a person in the United States can have, but as we learned their overall income tax rate is almost certainly going to be less than that, because you need to account for the lower brackets for parts of their income.
There are unusual circumstances where that might not be true, and the most common would be the Alternative Minimum Tax (AMT). The predecessor to the AMT was adopted in 1969 as a way to prevent high-income families from reducing their entire tax burden to zero through the use of benefits and deductions. The AMT calculation excludes certain kinds of tax breaks, and can raise the tax rate for certain households.
In the past, there were tax brackets with much higher marginal rates. In the early 1950s, the highest tax brackets were above 90%. Despite that, no one paid actual tax rates that high. These taxes were still marginal, so most of an average person’s income would be taxed at rates substantially lower than that. Even for the wealthiest people in the United States at the time, the above 90% rates only applied to money that they made over $400,000. Today, in 2016, that is the equivalent of making more than $3.9 million dollars, and all of the money less than that would be still be taxed at a lower rate.
Back to today, a good accountant is the best person to figure out how to make your tax rate as low as possible. Generally, our work consists of figuring out the best way to lower your Adjusted Gross Income (AGI), to maximize your exemptions and deductions to lower your effective tax rate. As you can tell from this short article, these things are very complex and a good professional by your side is definitely a good thing to have.
If you have questions about your tax rates or tax brackets, or deductions and exemptions, or just “finances,” please feel free to give us a call.