I know the title of this article is a bit provocative, and rest assured that I do not in any way mean for this to be a political argument; I just know the subject of taxation can be a boring one, and as a CPA I like to make taxes much more interesting if possible.
For example, you should check out some of our favorite tax saving strategies, which involve stacking your tax-free dollars for HUGE savings (potentially thousands of dollars in a single year).
But back to the matter at hand, I’m going to focus on the concept of marginal tax brackets and the federal income tax calculation in general. There’s an incredible amount of confusion when it comes to “tax brackets”; many people, even financially literate and educated ones, think that your ‘tax bracket’ means that every dollar of your taxable income gets multiplied by that tax rate and that’s the amount of federal income tax you owe.
That is not the case at all.
Marginal Tax Brackets
What people think of as your tax bracket is really what’s known as your ‘marginal tax bracket.’ This means that your next (marginal) dollar is taxed at this rate, not every dollar that came before it. The tax brackets for 2016 are as follows for taxable income (the amount after all your deductions) for a couple that files married filing jointly:
(See this article at taxfoundation.org to see the tax tables for all taxpayers.)
As you can see, the first $18,550 of everyone’s taxable income is taxed at a 10% rate. Then the next $56,750 is taxed at a 15% rate.
For the vast majority of taxpayers, this is the highest rate they’ll pay on their next dollar of income because most people don’t have taxable income above $75,300.
Example: Family of four with a $100,000 income
To illustrate the tax calculation for a family of four with a $100,000 income, I’m going to calculate their tax liability just using the regular standard deduction and personal exemptions, so this is as conservative as possible. This assumes they do not itemize their deductions and have nothing else of note other than that they are saving 10% of their income in a 401k like we recommend.
I understand $100k is a significant amount of income in general (we are assuming two working spouses each making $50,000 per year), but I think that makes the results that much starker when you see how little most people are paying in federal income taxes (and how overblown most people’s protestations are about their “crushing” tax burden):
As you can see, we take their $100,000 income and subtract the deductible $10,000 that was contributed to their 401k account(s). We then take the remaining $90,000 and subtract the $12,600 standard deduction as well as the personal exemption of $4,050 for each family member ($4,050 x 4 = $16,200). The result is a taxable income of $61,200.
We look to the table above and the first $18,550 of this $61,200 is taxed at 10% ($1,855 tax liability) and the remaining $42,650 is taxed at 15% ($6,397.5 tax liability) for a total income tax liability of $8,252.5.
At this taxable income level this family would qualify for the Child Tax Credit on each of their two children, which reduces the tax liability by $2,000 for a total federal income tax liability of $6,252.5 on $100,000 of gross income. This equates to a 6.25% effective tax rate on the gross income.
All taxes paid:
- Federal Income tax: $6,252.5
- Federal Payroll tax: ($100,000 x 7.65%) $7,650
- Estimated State Tax @ 6%: ($61,200 x 6%) $3,672
- Estimated Property Taxes: $2,000 (middle-class home in Richmond, VA)
- Estimated Other Taxes (Sales, personal property, etc.): $1,000
- Total Tax Burden on $100,000 income = $20,574.5 for an effective rate of 20.57%
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Really nice explanation and I like what you said about people’s constant complaining! I have relatives just like that. Go live in Denmark and then tell me what you think of our taxes!
I like how you didn’t bring the mortgage deduction into the equation. Unless you have a whole ton of stuff to itemize or have a ridiculously expensive home, the mortgage deduction is highly overrated. I don’t think most people really understand how little it helps them.
Mr. 1500 recently posted…Thursday Anti-Rant: Think Happy Thoughts
Thanks — I’m glad you enjoyed the article! I tried to make it as clear and accessible as I could as I think it’s extremely important that people have a basic understanding of how the tax system works in this country.
Hopefully people understand that if someone with a $100k income with no special deductions whatsoever is only paying 20% total in taxes that that vast majority of people are paying much less than that. I think most people have this delusion that they pay “half their income to taxes” and it’s not even close to true…
what about ssi tax medicare tax and a few others
Joe,
I listed this out at the bottom of the article. A lot of the political talk is about how nearly half the country doesn’t pay “income tax”, so that’s why I distinguished between the taxes in the article.
I tried to paint the full picture near the bottom.
thanks,
Brad
This is an incredibly good article. I understood the marginal tax rate issue, but I wasn’t sure how the personal exemptions worked or how state and FICA were taxed separately. Been a long time since I prepared our own tax return, and we’re hit by the AMT here lately.
Also, in terms of the idea of the 40 percent being essentially freeloaders that’s been bandied about, you show how they do pay other taxes, of course (some, like sales tax, which hit the poor the hardest as a percent of income). I’d like to also note here that MOST of those not paying federal will do so in the future (e.g., students, the temporarily unemployed, etc.) or did so for a long time (e.g., lower income elderly retirees, disabled workers).
Thanks for your article!
Hi Kelly,
Thank you for the positive feedback — I greatly appreciate it! I thought this was an interesting look, and slightly different than how most people present it.
Always good to think through an issue in a slightly different way
Thanks again,
Brad
Lol I can’t believe that I understand taxes now! I really appreciate it. I didn’t know that for every marginal bracket reached, you pay the percentage of tax only for that margin and NOT every dollar before. Also I wasn’t aware that the money set aside for 401k wasn’t taxed. I thought by reaching one dollar into a marginal bracket gets you taxed for everything you made. Thanks again!!
Nice Jeffrey, I’m glad you got so much out of this article!! This is definitely important info and few people understand it, so you are way ahead of the game now
I would happily move to Denmark where yes my tax is higher but my education and medical expenses and general quality of life far exceeds that of the US. Your example does not at all reflect the true cost of doing business in America.
Preaching to the choir here, my man.
Great number crunching, for better and worse, taxes hit us all!
No Waste recently posted…Mrs. No Waste: A First Person Perspective On Multi-Level Marketing
haha, I thought you might enjoy this one…
Just trying to make it clear how our income tax system works. Hopefully people get something out of the article and walk away with a better understanding of how their income tax calculation works.
It’s always amazing how much whining there is in America about taxes when we have some of the lowest on the planet. Great overview!
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Thanks Nick — glad you liked the article!
LOVE this post. It bugs me so much when people say because top marginal tax rate is 40% that they pay $40,000 out of $100,000. I think that kind of misunderstanding (or willful non-understanding) prevents us from having the kind of substantive conversation needed on taxes in this country.
I’m glad you liked the post so much and I completely agree with your comments (great phrase with the “willful non-understanding”). It is impossible to have a substantive conversation on the topic because people don’t even have a rudimentary understanding of how the taxation system works in the US.
All they reflexively know is that “they pay too much” and that any tax cut by definition is a good one. That’s just not good enough…
Great explanation…I think a lot of people are confused when it comes to taxes. I like how you break it down, makes it simple to understand. People complain a lot about taxes, but there are plenty of deductions and credits that they don’t take into account.
I’m glad you liked it; I tried to make it as easily digestible as possible since a basic understanding of these concepts is quite important.
To your point, it’s essential that people understand that they are only taxed on a portion of their gross income and that the remaining taxable income is not just simply multiplied by one tax rate — everyone reaps the benefits of the graduated income tax brackets.
Many people at this $100k income level would pay less than $6,400 in federal income tax as they would have more deductions than I presented in my simplistic example; I suspect this would surprise many people as $100k is a significant income in most parts of the country.
I just found your blog thanks to the post over at 1500 Days, and I really liked this post. I will say that things are not as great for a single person earning $100k as it is for someone earning $100k with a stay at home spouse (or with a spouse who earns significantly less). The tax code seems to benefit a married couple with disparate incomes. But still, the numbers don’t lie and I think this is a great breakdown of how the progressive tax applies favorably to even a high six figure income.
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Glad you found us and liked this post — I appreciate you taking the time to look around!
You’re absolutely correct that the tax code doesn’t favor a single person making $100k; I just did a quick back of the envelope calculation using the same $100k less the $10k 401k contribution and the single standard deduction and personal exemption and the federal tax liability is nearly $16,000 or almost $10,000 more than the hypothetical family of four with two kids. That’s a huge difference…
I have had this discussion with a single friend of mine that feels the same way. I will if I can try to defend the disparity between the two. Families are expensive. The costs of education and daycare for just my daughter is almost $5k/yr. That does not include clothing, food, travel expenses to and from places etc. Additionally if children are raised well and become contributing members of society they are adding to the system. The tax code is somewhat organized as incentive to grow families and to continue the cycle as it may be. A single individual that only puts in for themselves then retires and draws SS will essentially become a burden on the system (no offense). While the family that does the same has new contributing people that keeps the system propped up from the bottom per se.
Nice job not paying taxes! I paid over $100,000 a year in federal income taxes alone for the past 10 years and feel sick!
Can you explain what Personal Exemptions is and how to get one? I’m trying my best to reduce my tax bill and get as much freebies from the government as possible too.
Thanks!
Sam
Thanks for stopping by! I’m a big fan of your site…
This article was more of just a hypothetical family rather than my family specifically. I was really trying to show how little in taxes the vast majority of families actually pay just with the standard deduction and personal exemptions we all qualify for (and you certainly take on your return).
If you’re looking for some great and really advanced reading, I suggest you check out the Mad FIentist website; Laura and I are blown away by his articles
Great post. Any insight on Roth 401k vs Traditional 401k? I was contributing to traditional forseveral years then a few years ago switched ro Roth but not sure if that is the best choice. Alot of blogs I am reading lately seem to recommend deferring taxes.
This is a fantastic question! For years I’ve come down on the side of Roth IRSa, but after reading the site the Mad Fientist, I think he has convinced me to only use traditional IRAs and 401ks. I strongly recommend you read through that entire site.
Thanks for creating such a great article. I found it very informative and engaging.
Good wishes
People aren’t complaining about “crushing” federal taxes, they are complaining about their overall tax burden. This calculation is overly simplistic and does not include Medicare, social security, state, and any local taxes. It also doesn’t include property taxes, tax on gasoline, tax on cell phone plans, cable/satellite TV, internet, state sales tax, and all the other “hidden” taxes people are paying.
Add to that the sky-rocketing cost of health care and college tuition for those 4 kids and I for one feel like I am going backwards. 10 years ago I made around $48k, now I make $90k. During that pay-scale increase I went from getting reduced school lunches, medical assistance, zero family contribution for college tuition, and 8k-10k tax returns (way more than I paid in). I can honestly say I am only “very slightly” better off than I was at 48k. Furthermore, in my attempt to better myself I am left with $64,000 ($679 monthly) in student loans to pay back. In hind sight, I may have been better off not trying to better myself.
I am not complaining, I am merely pointing out that as your income goes up it is not only federal taxes that hit you, it is a whole host of things that affect the real bottom line: how much money you have left over to meet all your financial obligations.
I understand your frustration. I just calculated our taxes for this year at this same income level with three children and we still owe taxes! Mind you, a heck of a lot of our income goes to sale taxes, state, and local; medical insurance, rent (we live in New York City), and I have student loans. We also have childcare expenses throughout the year for all three kids. I can’t believe we still owe!
Thanks for writing this clear example. However, …
You should add second half of payroll tax (it is paid by employer in case you do not know), it will get tax rate to 28%.
Two child credits of $1000 does seem very convincing – do people at this level of income really qualify?
$2000 in real estate taxes seems pretty low. I am living in another state, my house is worth less than $400k (rather low by today’s standards) and I am paying $8k/year. We do not have any industries so tax burden is relatively high, but I doubt that it is 4X.
So, I would say 33-35% of overall tax load will be a reasonable estimate.
Just an FYI, I live in Utah with a home value of around $300k. My real estate tax (property tax) every year is $2200. I am not sure where you live, but $8k seems outrageous.