Hey Paul: My accountant told me that I’m in the 15% tax bracket. What does that mean? Am I paying 15% of my income to the IRS?
Bracketed in Nicholasville
The concept of tax brackets doesn’t come up too often unless you are talking to your CPA, financial advisor or an economics professor. The simplest and most important thing that your tax bracket can tell you is how much tax you paid on the last dollar you made in the year. Unless you are right on the edge of a tax bracket it also tells you how much each additional dollar of income will be taxed.
In your case you paid 15% in Federal taxes on part but not all of your income. Most of your income is untaxed or taxed at 10%. Putting all these taxes together means your average tax rate will be much less than 15%.
Putting some numbers on this will help. Suppose you are single and have gross income of $50,000. There are six general steps used in calculating the net tax liability.
Step 1: Your Gross Income of $50,000 is reduced by any “adjustments” to income. The primary one for many people is contributing to a tax-deferred 401(k) or IRA. Suppose you contributed $6000 to your 401(k) –- this will bring your Adjusted Gross Income (AGI) to $44,000.
Step 2: The Federal government does not tax the first $10,300 for singles – you are eligible for a $6300 “standard deduction” and $4000 “personal exemption.” You don’t have to do anything special to qualify for these deductions. If you do have state and property taxes, charitable gifts and mortgage interest expense that collectively exceeds $6300 you can itemize and deduct the higher amount. Assuming you just take the default deductions your “taxable income” will be $33,700.
Step 3: There are seven Federal taxes brackets ranging from 10% to 39.6%. The taxes are applied in a staircase fashion – as your annual income rises it can put you in a higher tax bracket. For Singles the first $9225 of taxable income is taxed at 10%. From $9226 up to $37,450 of taxable income is taxed at 15%. Since your taxable income is $33,700 the 15% tax rate would be applied to $24,475 of income that falls in your top tax bracket. Your tax at this stage would be about $4594.
Step 4: The Federal government subsidies many things society supposed wants more of – children, college education, green energy, etc. Credits are a terrific bonus as they are a direct dollar-for-dollar reduction in tax liability. The one catch is that many credits are “nonrefundable” – that is they can only reduce your tax liability to zero. Suppose you bought a Tesla this year and are eligible for a $7500 credit. However since your tax liability is only $4594 the credit only wipes out $4594. The good news is that you are living in America for free!
Step 5: Well almost free. The IRS makes a few adjustments such as tacking on Social Security and Medicare taxes that weren’t paid during the year. The IRS may also ding you for early (before age 59.5) retirement withdrawals and the infamous Obamacare mandated “health care individual responsibility” tax penalty.
I’ll assume none of these apply to your situation.
Step 6: Settling up – the IRS looks at what you’ve already paid in taxes you’re your pay check or estimated quarterly payments. The 1040 oddly adds in refundable credits as part of Payments. Most households overpay and look forward to a large refund upon filing their taxes. In your case let’s assume you paid $2400 in Federal taxes out of your paycheck in 2015. Since you don’t have any tax liability you can expect the tidy sum of $2400 directly deposited into your bank account.
So in what might seem like forever ago you asked what it meant to be in the 15% tax bracket. That was the highest tax rate applied to your taxable income in Step 3. However your actual net Federal tax liability is zero! In fact if you head earned $63,125 instead of $50,000 your tax liability would still be zero!
Of course there are other taxes that you’ll be paying – Social Security at 6.2% and Medicare at 1.45% of gross income. Kentucky state income tax brackets are lower than Federal rates but you’ll likely pay a few percent of your income to Frankfort. So your true “tax bracket” is more like 10% as you are hit with payroll taxes and state income taxes while keeping below the Federal government’s tax threshold.
For those who prefer to work crossword puzzles rather than solve math problems, keep in mind that several of the top tax preparation companies offer free or low cost tax software. See last week’s More-Than-Money column for more info and links.
On that note let me give a shout-out to the AARP Tax Prep team who are offering FREE tax preparation with a target audience of moderate-income, senior citizens but they will assist any age or income level. They do have limits on the complexity of the returns (e.g. no farming income or business with an inventory like MaryKay). The AARP offers tax preparation Monday and Wednesday’s from 8:30 to 11:30am at the Jessamine Public Library up to the week before this year’s tax filing deadline of April 18.
Dr. Paul Hamilton is an Associate Professor of Economics at Asbury University and a CFP providing financial coaching to middle-class Americans. He is available to provide free workshops to churches, local businesses and other groups.