Despite my income putting me in the 22% tax bracket for the 2019 year, my effective tax rate was only 11.4% – essentially half of the marginal tax rate!
Maybe this already makes sense to you. However, there definitely seems to be some misconceptions out there surrounding one’s tax liability (what you owe in taxes) after the end of each year, and I am hoping to put those bears to bed with this post as we approach the filing deadline.
Tax deductions
Each year when you file your taxes, you have the option to take what’s called a “standard deduction” or an “itemized deduction”.
With the most recent changes to our tax code, the standard deduction is often the right choice. Unless you live in a State with high taxes, own a home, or donate large amounts of your pay to charity, there is a good chance that the standard deduction will give you a more favorable tax liability.
We’ll explore deductions in another post, but I’ll be using the current (as of April 2020) standard deduction of $12,200 for this post.
Tax brackets
The United States have what is called a “progressive tax system,” which means that income past certain points is taxed at progressively higher rates. See below for the tax brackets for money earned in 2019.
Many people think that the entirety of a single filer’s $55,000 salary would be taxed at a rate of 22%, but that is not the case! The example below should help to clarify how tax brackets work.
Example: Filling Your Tax Buckets
Let’s look at the aforementioned single filer’s salary of $55,000, which falls pretty squarely into the 22% bracket.
Take this metaphor to start off: each marginal tax rate (10%, 12%, 22% etc.) is a small bucket sitting inside of a larger bucket, with the largest of the buckets representing the marginal rate that your income falls into.
The first step is to subtract your deductions from your gross (pre-tax) salary, as deductions function as a 0% bucket before you start working through the marginal tax brackets. In other words, the first $12,200 of earned income is ours to keep without being taxed at all, and sits off to the side in the gold “deduction” bucket.
After subtracting the standard deduction of $12,200 from our $55,000 salary, we are left with a taxable salary of $42,800 – which still falls into the 22% tax bracket. This tells us that the 22% bucket will be our biggest.
One step down from the 22% tax bracket is the 12% bracket. In our metaphor, this means that there is 12% bucket sitting inside of our 22% bucket. Finally, a 10% bucket (reflecting the smallest bracket) sits within the 12% bucket.
With the first $12,200 sitting happily aside in the standard deduction bucket, we then begin pouring our taxable salary ($42,800) into the nested buckets.
Once the smallest (10% tax rate) bucket has filled up, the money overflows and begins filling the 12% tax rate bucket. Once the 12% bucket overflows, the remaining money is poured into the final 22% bucket until there is no more left to add.
The 22% tax rate bucket has room for taxable salaries of up to $84,200, and we only have $42,800 to pour in. This means that we won’t be needing the next bucket size up (24% tax rate) this year!
Ultimately, the amount of money in each bucket is taxed at that bucket’s marginal rate:
- The first $9,700 you earned is taxed at 10%.
- The next portion – $39,475 minus the $9,700 that has already been taxed at 10% – is taxed at 12%.
- The remainder – your taxable salary ($42,800) minus the $39,475 that has already been taxed at 10% or 12% – is then taxed at 22%.
Calculating your effective tax rate
With that out of the way, let’s find the effective tax rate for our example salary of $55,000. The formula is pretty simple:
Effective Tax Rate (%) = 100 * (Taxes Paid / Taxable Salary)
Your Taxable Salary is your total pay minus any deductions or tax exempt earnings. In this instance we will just subtract the standard deduction ($12,200) from our total:
Taxable Salary = $55,000 – $12,200 = $42,800
Next, apply the calculations from our bucket formula above to find the Taxes Paid:
Taxes Paid = ($9,700 * 0.1) + (($39,475 – $9,700) * 0.12) + ($42,800 – $39,475) * 0.22)
= ($9,700 * 0.1) + ($29,775 * 0.12) + ($3,325 * 0.22)
= ($970) + ($3,573) + ($731.50) = $5,274.50
Finally, we plug our Taxable Salary and Taxes Paid into the original equation to find our true tax rate:
Effective Tax Rate = 100 * ($5,274.50 / $42,800) = 12.3%
Just like that, we’ve got our number – and hopefully an understanding of why ultimate taxable liability is a more palatable percentage of our income than the marginal tax rate might imply.
Crunch some numbers of your own, and keep reading our other posts to learn how to reduce your taxable liability while saving for the future.