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 making $175,000/year and her husband, Jim, is a university professor with a $125,000/year compensation. Together they make $300,000/year. After deductions and adjustments, they have a taxable income of $257,000/year.
How much federal tax will they pay if their tax status is “married filing jointly?”
Calculating federal tax using the new 2018 tax brackets
The new tax bill signed in December, the Tax Cuts and Jobs Act (TCJA) of 2017, went into effect on January 1, 2018, and will impact most taxpayers for the 2018 tax year. There are still seven tax brackets, but the percentages and dollar amounts within the brackets have been modified. The chart below shows the changes between 2017 and 2018 in tax brackets for a married couple filing jointly.
This is how Jim and Shirley’s 2018 federal income tax is calculated:
- $19,050 taxed at 10% = $1,905 federal tax
- $58,350 taxed at 12% ($77,400 minus $19,050) = $7,002 federal tax
- $87,600 taxed at 22% ($165,000 minus $77,400) = $19,272 federal tax
- $92,000 taxed at 24% ($257,000 minus $165,000) = $22,080 federal tax
Shirley and Jim will pay $50,259 federal tax on their $257,000 taxable income in 2018 ($1,905 + $$7,002 + $19,272 + $22,080 = $50,259 total federal income tax). For simplicity, we’re ignoring any deductions or credits.
The marginal tax rate is the tax rate on your final dollar that’s taxed. For Jim and Shirley in 2018, that would be 24% because their $257,000 taxable income falls into the range of money that is taxed at the 24% rate ($165,001 – $315,000). Their “final dollar” tax was at the 24% rate.
From the chart above, you can see that their marginal tax rate has decreased from 2017. In 2017, their marginal tax bracket was 33%.
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).
Andrea L. Blackwelder, CFP®, ChFC 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 Wisdom Wealth Strategies.