The federal income tax
The federal income tax system is a complex and often confusing web of rules, regulations, and laws. For perspective, the Internal Revenue Code is comprised of over 3.8 million words and 9,000 sections compared to nearly 800,000 words and 66 books in the Bible.
A fundamental aspect of the federal income tax system is that it is based on a progressive tax. While it is true that when you earn a higher income you are taxed at a higher marginal tax rate, meaning the rate at which each additional dollar of your income is taxed, you are not necessarily taxed at a proportionally higher overall effective tax rate. This is because the tax system is designed to tax different portions of your income at different rates based on your income level.
Let’s assume that in the year 2023, you were single and earned a taxable income of $80,000. Under the current tax code, your income would be subject to the following tax brackets:
- 10% on income up to $11,000
- 12% on income between $11,001 and $44,725
- 22% on income between $44,726 and $95,375
- 24% on income between $95,376 and $182,100
- 32% on income between $182,101 and $231,250
- 35% on income between $231,251 and $578,125
- 37% on income over $578,125
Let’s assume that in the year 2023, you were single and earned a taxable income of $80,000. Under the current tax code, your income would be subject to the following tax brackets:
- 10% on income up to $11,000
- 12% on income between $11,001 and $44,725
- 22% on income between $44,726 and $95,375
- 24% on income between $95,376 and $182,100
- 32% on income between $182,101 and $231,250
- 35% on income between $231,251 and $578,125
- 37% on income over $578,125
Using these tax brackets, your income would be taxed as follows:
- The first $11,000 of your income would be taxed at a rate of 10%, resulting in a tax of $1,100.
- The next $33,725 of your income would be taxed at a rate of 12%, resulting in a tax of $4,047.
- The next $35,275 of your income would be taxed at a rate of 22% (this would also be your marginal tax rate), resulting in a tax of $7,761.
- In total, your tax owed would be the sum of these amounts, or $12,908.
A common misconception with the progressive tax system is that your marginal tax rate (the bracket to which your highest tax rate is applied) represents your overall tax rate. If that were true, the example above would have resulted in your total tax owed as $17,600 ($80,000 22%). Your marginal tax rate can and often does play an essential role in understanding your personal tax situation, however what you are generally most concerned about is your effective tax rate. Your effective tax rate is a simple calculation you can do after you have determined your total tax.
Assume the same figures as before:
- Total Tax Taxable Income = Effective Tax Rate
- $12,908 $80,000 = 16.14%
The difference between your marginal tax rate and your effective tax rate is important to understand because it can impact your tax planning decisions. Your marginal tax rate is useful for understanding the impact that additional income will have on your tax bill. Say you are considering taking on a new job that pays $10,000 more per year, understanding your marginal tax rate can help you estimate how much additional tax you will owe.
Your effective tax rate, on the other hand, is useful for understanding your overall tax burden. It takes into account all of the tax brackets that apply to your income and provides a more accurate picture of the average amount of tax you pay on your income. This can be helpful for budgeting and financial planning.
By understanding these concepts, you can make more informed decisions about your finances and plan for your tax obligations accordingly.
