Tax Brackets Are Not as Scary as You Think: A Simp
le Guide to Keeping More Money
There is no need to lie, just at the mention of the word tax, most of us turn to cold sweat. Documentation, receipts, and incoherent government lingo--it makes it seem like you are required to wear a decoder ring to file. Among all the tax concepts that make people feel a headache, there is one that is the most misconstrued; the humble tax bracket. I cannot even count the number of occasions I heard a friend or a colleague say so, I refused to take the overtime it would take me to the next tax bracket and I would make a loss! It sounds logical, right? When you shatter an invisible barrier the government bites a larger piece out of all you make. The thing is at this point that will save you a ton of stress and money, That is an all out and all in myth. Learning how tax brackets really work is one of the greatest moves you can make in terms of your finances. It is the difference between worrying that you might get a raise, and glorifying it. And, then, so as to deveil the veil and shred this in plain English, without the baffling arithmetic.
The Big Idea: It’s a Tiered System, Not an On/Off Switch
The fact that the United States employs a progressive or a gradated tax system is the most significant to keep in mind. Imagine it as a series of steps or tiers of a cake. Your revenues are not taxed at one rate. Rather it is divided into portions and each portion is taxed at a rate. Suppose that you are filling a row of buckets. There is a small bucket which fills first, then a medium one and then a large one. The side of each bucket is painted with the different tax rate. Just like the next bucket is only filled when the one before it is overflowing. This is the core of how tax brackets function. Your first chunk of income is taxed at the lowest rate. The next chunk is taxed at a slightly higher rate, and so on. You are never in just one bucket; you’re always in several at once.
Let's Get Our Terms Straight
Before proceeding further, we should define two important phrases which you will hear constantly. It is important to know the difference. Your Marginal Tax Rate: This sounds fancy but this is not hard. This is a tax rate on your last dollar of earnings. It is the interest on your largest bucket. A person mentions that he or she is in the 22 percent tax bracket; he or she is referring to the marginal rate. It is the maximum percentage charged on their full earnings. Your Effective Tax Rate: This is what you are actually paying in terms of tax. It is the amount of tax that you paid within a year divided by the amount of income you received. Due to our tiered bucket system, your effective rate of tax always is less than your marginal rate--in many cases by a long way. It is this figure that actually informs you of the percentage of your income that was paid to the taxes.
A Walk-Through Example: Meet Sarah
A story will bring this to reality. Suppose we take the case of one of our friends Sarah who is single. She deduces sixty thousand dollars in her taxable income. So, we shall now take some simplified tax rates (they are not the exact current rates but roughly close enough to demonstrate how it works). Bucket 1: The first 10,000 of income is taxed at 10% rate. Bucket 2: Earnings between 10,001 and 40,000 are subject to 12 percent taxation. Bucket 3: Between $40,001 and 85,000 Income is taxed at 22 percent. What is the calculation of the tax bill of Sarah? It happens in stages. First, she fills Bucket 1. The initial ten thousand dollars received by her are subject to the ten percent rate of tax. A thousand dollars tax. She then goes on to fill Bucket 2. This bucket includes the income between a bit more than ten thousand dollars to forty thousand dollars. It is a thirty thousand dollar piece of her revenue. This portion is subject to a twelve percent tax or thirty six hundred dollars. There is still more income that she should cover! She has got sixty thousand dollars and she has been made to pay forty thousand in taxes. The other twenty thousand dollars is included in Bucket 3. This amount is subject to twenty two percent tax thereby amounting to forty four hundred dollars. To get her total tax bill we now simply add up the amount of tax paid out of each bucket: Bucket 1: $1,000 Bucket 2: $3,600 Bucket 3: $4,400
Total Tax: $9,000
What does this imply to Sarah then?
What makes her Marginal Tax Rate 22% is the rate to which she is taxed on the topmost level of income.
Her Effective Tax Rate is calculated as the total tax/total income: $9,000/60,000=15%. See? Her total tax rate is significantly lower than the marginal one.
Slaying the Dragon: The Raise Myth Now, back to the big fear. If Sarah gets a five-thousand-dollar raise, bringing her taxable income to sixty-five thousand dollars, does she suddenly pay twenty-two percent on all her money?
No. A thousand times no.
The new money only is taxed, the five thousand dollars which increased her earnings to sixty-five thousand, at her highest rate, which is twenty-two percent. Her first sixty thousand dollars still goes to be taxed in precisely the same way as it was once before: in the 10, 12 and 22 percent portions. She would pay an additional tax of $1,100 (22% of $5, 000) and she would bring home an additional amount of 3,900. To have an increase or even work an overtime will always keep you with more money in your pocket. The concept that you might bring home less is a ghost that must not be resurrected ever again.
How to Use This Knowledge as a Superpower
This is not simply knowing how to sound intelligent but this is a practical tax plan, which may help in making your financial choices.
The Retirement Contributions are Your Best Friend: The money you contribute to any traditional 401(k) or IRA is subtracted out of your top-line earnings. Being close to the top of a bracket you might save more to your retirement and rather than pocketing the money in a lower marginal bracket you save money at your highest rate. Roth vs. Traditional Decisions: This insight is important. With a low marginal tax rate at the moment, it may be a brilliant move to pay the tax upfront with a Roth IRA. In case you are currently in a high bracket but would be in an inferior one in your retirement, then the traditional IRA or 401(k) would probably suit better. It is all a question of wagering over which of the two buckets will be filled up later. Long-Term Planning: Marginal rate is relevant to make you think about the tax implications of selling investments or acquiring side income. Instead of making fearful decisions, you can be making informed decisions.
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