The title of this post promises to be a fast five-minute read, then it mentions understanding the federal tax code. No, this is not a late April Fool’s joke. I would need five years to understand the whole tax code – all I want to accomplish with this piece is to have you understand the difference between your marginal verses your effective tax rate. Now that we have taxes done for 2022, let’s refresh some definitions and look forward.
Bill, Corey, and I in our client reviews talk a lot about taxable income and what tax bracket our clients are in. As advisors, we often say something to the effect of “we don’t want to push you up a tax bracket”. I hear a lot of my peers talk about – “I don’t want to go up a tax bracket this year,” “my bonus is going to push me up a bracket! My taxes are going to be a wreck this year!”, etc. Sometimes these blanket statements don’t quite convey what we are talking about when it comes to tax planning.
The first thing we need to remember about the tax code is that it is marginal – meaning everyone pays the same percentage on certain levels of taxable income. That percentage of taxation grows as the bands of taxable income grow. This means that myself and Bill Gates both are going to pay $0 of taxes on our first $11,000 of taxable income (assuming for simplicity that we both file as Single taxpayers) because that is the 0% marginal tax bracket. Our next $1 of taxable income that we earn after our first $11,000, will be taxed at 10% which is the next step up and the next marginal bracket. In this example, this means that our total tax bill would be $0.10 on our $11,001 of taxable earnings. No matter how much money myself and Bill Gates make, our first $11,000 of earnings will be taxed at 0%. However, Bill Gates and myself will end up in different top marginal tax brackets because I will stop earning within a bracket, and he will keep going. Your top marginal tax bracket is the rate at which your last earned taxable dollar is taxed, this rate can go up as high as 37% in 2023.
An important fact to remember while you are evaluating a tax strategy: only the amount of money that pushed you into the next bracket will be taxed at that rate, not your entire earnings. So, if your tax preparer or financial advisor mentions that “this might push you into the next bracket” don’t be scared that this means all your earnings will be taxed at this higher rate.
The effective tax rate is the one you hear Warren Buffet talking about in the news, that he pays a lower tax rate than his secretary. This number can be different for each individual taxpayer and isn’t listed anywhere in the tax code. The effective rate you pay is the percentage of taxes owed on your overall taxable income. This is lower than your highest marginal rate because it takes into consideration that you paid less taxes on your earlier taxable income. The effective rate makes up for the fact that you are paying different percentages on levels of income. This is the percentage that you can do simple math with to figure out how many dollars in taxes you paid. For example if I had $100,000 of taxable income and said that my effective rate was 15%, you would know that I had a $15,000 tax liability.
Understanding your marginal verses effective rate is important for tax planning conversations, and for conversations at the water cooler. Share this blog post with your teens and college aged kids so they can get a head start on understanding their taxes.