This article is part of our 52 week journey through Bill’s latest book, The Graduate’s Guide to Life and Money. Each week, a full excerpt from his book will be presented from beginning to end. To get your copy of his book, visit www.TheGraduatesGuide.com.
One of the only tax-related concepts that I find people misunderstand more than the tax returns themselves are the tax brackets. People usually don’t understand how our progressive tax system works. I’ll admit, it is quite confusing, at least in the beginning. To make things more complicated, the tax brackets change constantly based on new tax laws such as tax relief laws or tax increase laws (you can guess which one makes them go up and which one makes them go down).
So what is a progressive tax system? Basically, the more money you make, the more you pay. But wait, there’s more. Not only do you pay more, you also pay a larger share of your income. As an example, if you make $1,000 and pay 10% you would pay $100 in taxes. If someone else made $10,000 and paid 10% they would pay $1,000. Both of you paid 10% in taxes, but the person who made more paid more. That is a flat-tax system. Now if the second person had to pay 20% because they made more money, they would pay $2,000 in taxes (20% x $10,000). You see, not only did they pay more ($2,000 compared to $100) but they also paid a larger share of their income (20% compared to just 10%). That is a simple example of the progressive tax system. As you’ll see, it is slightly more complex than that.
An important point to remember is that different amounts of your income are taxed differently at each bracket. In other words, if you are in the 33% tax bracket it does not mean that you pay 33% taxes on all of your income. If you are in the 33% tax bracket, your marginal tax rate is 33%. You will pay 33% on each additional dollar you make. The first portion of your income was taxed at just 10%. Look at the example below, based on the 2007 tax rates for a single filer.
For this example, we’ll assume the taxpayer has $40,000 in taxable income. As you can see, this taxpayer would be in the 25% tax bracket. To calculate the tax liability, take the first $7,825 x 10% = $782.50. The next $24,025 x 15% = $3,603.75 and the last $8,150 x 25% = $2,037.50. So, this person’s tax liability is $782.50 + $3,603.75 + $2,037.50 = $6,423.75.
As you can see, they are not paying 25% of all of their income, just the portion that is greater than $31,850. If they were to earn $1 more, they would pay 25 cents in tax on that dollar. If they were to get a $1 tax deduction, they would pay 25 cents less in taxes.
Of course, you also pay other taxes as well from your income. Most people pay a state tax. Also, we pay Social Security tax and Medicare tax. Your employer normally takes these “payroll” taxes directly out of your paycheck. Social Security and Medicare combine for 15.3%. However, your employer pays 7.65% and you pay 7.65%. Your employer may also take other non-tax payments out of your paycheck including your 401(k), health insurance, life insurance, etc.
Perhaps your biggest concern is minimizing your tax burden. The details of how the system works may not be as important as making sure you don’t pay any more than you absolutely have to. In order to minimize what you pay in taxes, you have to first understand the three basic ways of paying less, credits, deductions, and deferrals.
A tax credit is a dollar for dollar reduction in the amount of taxes you will have to pay. For instance, a $100 tax credit reduces your total tax contribution by $100. That’s simple enough. A tax deduction reduces your total taxable income by the amount of the deduction. Another way to look at it is that a deduction reduces your tax contribution by the amount of your tax bracket. For example, if you are in the 25% tax bracket and you get a $100 deduction, you will save $25.00 ($100 x 25%) in taxes. As you can see, you want to make sure you claim all of the credits that you are eligible to take.
Bill Pratt is a former credit card executive turned student-advocate. He is the author of Extra Credit: The 7 Things Every College Student Needs to Know About Credit Debt & Ca$h and The Graduate’s Guide to Life and Money. Bill speaks at colleges to educate and entertain students about real-life issues in money, leadership, and success. His goal is to help students succeed personally and financially so they can improve the lives of those around them. You can learn more at www.ExtraCreditBook.com or www.TheGraduatesGuide.com.