What is your Effective Federal Income Tax Rate?
by Stan Corey
One of the tricky things to understand about income taxes is what your actual tax rate is. In most cases people tend to refer to their “tax rate” as being the “tax bracket” they are in. For 2018, the tax brackets start at a taxable income level of $0 to $9,525 for single taxpayers and $0 to $19,050 for married taxpayers filing jointly and places them into the 10-percent tax bracket. Taxable income above that amount is taxed at 12 percent up to $38,700 and $77,400 respectively. The brackets then go to 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent for taxable incomes over $500,000 for singles and over $600,000 for married taxpayers. This is referred to as a “regressive” tax system because the tax rates increase with income. Note that the married, filing jointly tax brackets are double the single tax rates until you get to the top rate where married, filing jointly hits the maximum rate at just 20 percent over the income level for a single person. The income levels at these rates are due to change with inflation in the future, however. And they call this tax simplification!
If the “tax bracket” is not the effective tax rate, what is it then? Let’s take a look at an example. A couple who are married and filing jointly has a gross income of $100,000, and they have three children. Under the new tax rules, they would either take a “standard deduction” of $24,000 or take a deduction based upon the itemized deductions listed on their Schedule A. But let’s say they are renting or do not have enough itemized deductions and would be better off taking the standard deduction. That brings their taxable income down to $76,000, resulting in a tax of $8,742. However, they have three children, so they also get a “child tax credit” of $2,000 per child or $6,000. Note that a “tax credit” is a credit against the actual amount of taxes due, not a deduction against the amount of income. As a result, the net amount of tax due becomes $2,742 ($8,742 minus $6,000).
So, what is the “effective tax rate”? It is the amount of actual income tax due as a percentage of the gross amount of income before any deductions or credits. In this illustration it would be an effective tax rate of 2.7 percent ($2,742/$100,000). If they did not have children, then the effective tax rate would be 8.7 percent. If you were to look at the tax bracket that the couple was in based upon their taxable income of $76,000, it would be a tax bracket of 12 percent. If their taxable income were over $77,400, then they would be in the next tax bracket of 22 percent. Any taxable income above that amount would therefore be taxed at 22 percent, a big jump!
How does this help you with your income taxes? Normally if you are doing tax planning, before the end of the year, you should look at income tax you may owe to see if taking capital gains or losses might help you stay within a certain tax bracket. Since we are already into 2019, however, you might still be able to get a deduction by contributing to a tax-deductible IRA, if you are eligible, before you file your tax return. You want to contribute an amount that can reduce your overall income taxes by dropping you into a lower tax bracket. In the illustration above, if their income were just $10,000 higher, they would have been in the next tax bracket and paying 22 percent on the income above $77,400. This would lead to an additional $1,892 of taxes due. If that were the situation, a tax-deductible contribution to an IRA of $8,600 would bring their taxable income below the bracket threshold and save $1,892 of additional income taxes. That would be like getting an immediate return on your investment of 22 percent!
For many people, all these numbers may be confusing, but just think of the poor guys and gals at the top of income earners who have just received notice that their deduction for real estate taxes and state and local income taxes has been limited to no more than $10,000, and mortgage interest deductions has also been reduced. Their effective tax rates went up, not down with last year’s tax reform!
Stan Corey has been a Certified Financial Planner Professional (CFP), Chartered Financial Consultant (ChFC), and Certified Private Wealth Advisor (CPWA) for almost 40 years. Though retired from the day-to-day activity of providing financial advisory services, he continues to consult in specialized areas as a financial fiduciary. Stan is a sought-after expert who regularly provides financial commentary at national conferences, in print and online publications, and on TV. He has a reputation for taking complex financial issues and making them understandable to the average person. He likes to say he is a “financial translator.” He has published two books: a novel, “The Divorce Dance,” in 2016, and a non-fiction work, “When Work Becomes Optional,” in 2018. Web site: www.stancorey.com.