The U.S. tax system is a graduated tax system, as opposed to a flat tax system. What is the difference? How does it work? When you hear the term “marginal tax bracket,” what does it mean? Let’s look at an example to help us understand these concepts.
Shirley is a systems analyst earning $156,400/year and her husband, Jim, is a university professor with $125,000/year in compensation. Together they earn $281,400/year. After the standard deduction of $24,400, they have taxable income of $257,000/year.
How much federal tax will they pay, prior to adjustments, if their tax status is “married filing jointly?”
Calculating federal tax using the 2019 tax brackets
The Tax Cuts and Jobs Act (TCJA), signed in December of 2017, went into effect on January 1, 2018. TCJA resulted in seven tax brackets, which are typically adjusted slightly each year for inflation. The chart below illustrates the 2019 brackets.
This is how Jim and Shirley’s 2019 federal income tax is calculated:
Bracket one: The first $19,400 of income is taxed at 10% = $1,940 of federal tax.
Bracket two: The next $59,549 of income is taxed at 12% ($78,950 minus $19,401 = $7,146 of federal tax.
Bracket three: The next $89,449 of income is taxed at 22% ($$168,400 minus $78,951) = $19,679 of federal tax.
Bracket four: The remaining $88,599 of income is taxed at 24% ($257,000 minus $168,400) = $21,264 of federal tax.
Add the four tax amounts together. Shirley and Jim will pay $50,029 of federal tax on $257,000 of taxable income in 2019 ($1,940 + $7,146 + $19,679 + $21,264). For simplicity, we’re illustrating taxable income after deductions and before credits.
The marginal tax rate is the tax rate on the final dollar that is taxed. For Jim and Shirley in 2019, 24% is their marginal tax rate because $257,000 of taxable income falls into the 24% bracket ($168,401 to $321,450).
The effective tax rate is calculated by dividing total tax by taxable income. Shirley and Jim have an effective rate of 19.47%. ($50,027 divided by $257,000).
For comparison, if the U.S. tax system was a flat tax system, every dollar of taxable income would be taxed at the same rate. In a flat tax system, Shirley and Jim would pay $61,680 in federal taxes ($257,000 * 0.24 = $61,680).
At Wisdom Wealth Strategies, we specialize in making complicated subjects, like tax efficiency, understandable. If you would appreciate knowing more about your tax situation and how to manage your tax burden efficiently, we’d welcome a conversation with you.
Andrea L. Blackwelder, CFP®, ChFC, CDFA® and Joseph D. Clemens, CFP®, EA are the founders and partners of Wisdom Wealth Strategies. Their shared passion is simple: to bring financial empowerment, understanding, and peace-of mind to people who wish to improve their financial future, build wealth for their families, and achieve financial independence. Click here to find out more about how you can work with the Denver Financial Advisors at Wisdom Wealth Strategies.