Author Topic: Basic Taxes Question - How do brackets work?!  (Read 2254 times)

cbr shadow

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Basic Taxes Question - How do brackets work?!
« on: November 20, 2013, 08:42:00 PM »
This is probably a dumb question, but if I don't know the answer there have to be a lot of other people in a similar situation..
I'm confused about how the bracketing system works for our taxes. Do we get taxed for the dollars that fall into each bracket, or by your entire income level?
For example, if the brackets are:
$1-30,000 = 10% tax
30,001 - 50,000 = 12% tax
50,001 - 100,000 = 20% tax

If I make $55,000 salary do I get my salary taxed at 20% ?? 

I had someone recently explaining that I would get the first $30k taxed at 10%, the next $20k taxed at 12%, and only the last $5,000 taxed at 20%.   
Is this the way it works?

Zaga

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Re: Basic Taxes Question - How do brackets work?!
« Reply #1 on: November 20, 2013, 08:57:28 PM »
The brackets work like you said, the first bit is taxed at the lowest amount, the next bit at the next amount, etc.  So yes, only the part of your income that is in the highest bracket will be taxed at that rate.

You did leave something out though, at the bottom there is a portion of your income that is taxed at 0%.  If you have ever heard people talk about personal exemptions, the standard deduction, and itemized deductions, all of these determine how much of your income is untaxed.  For example a married couple with no kids gets 2 personal exemptions, 1 for each person in the household.  Each of these is worth I think $3,900 for 2013.  That part of your income isn't taxed.  Then there's the standard deduction of $12,200 (or itemized if you have enough deductions to beat that) for a married couple, also not taxed.

Finally, after you figure out all of your tax, there's one more way to reduce what you owe - with tax credits.  Some of the most common are the child tax credit ($1,000 off your tax bill for each qualifying child) and the earned income tax credit or EIC which is given to certain low income families.

Putting all of this together, for a family like mine in the 25% tax bracket, our total tax bill for 2013 was about 12% of our gross income.  So, our income is definitely not all taxed at the top bracket, I think I would cry!

huadpe

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Re: Basic Taxes Question - How do brackets work?!
« Reply #2 on: November 20, 2013, 08:59:42 PM »
The explanation you heard is correct.  The tax bracket you fall in is on what's called your marginal dollar, which basically means the next dollar of your income.

What your bracket is matters for stuff like deductions with IRAs and stuff. 

Take your example before:
30k@10% = $3000 tax
20k@12% = $2400 tax
5k@20% = $1000 tax
Total = $6400 tax

So your marginal rate is 20%, meaning if you add $1 in income, it costs $0.20 in tax, and if you take $1 away, it saves you $0.20 in tax.  But because most of your income is in lower brackets, you actually only pay 11.6% of your income in tax for that scenario.

Now, showing why marginal rates matter for decision making:

If you took a deduction of $3000 by putting it in a retirement account, then you would have the following table:
30k@10% = $3000 tax
20k@12% = $2400 tax
2k@20% = $400 tax
Total = $5800 tax

So you save $600 by putting $3000 into a retirement account, which is 20%, because that's your marginal rate.  The retirement account becomes much less attractive once you put $5000 in though, because you only save 12% on your 5001th dollar, since that's when you shift brackets.