Income Taxes

Unlocking the Mystery of Income Taxes

In Income Planning, Retirement Thinking, Tax Planning by Adam Cufr

There’s so much information in the headlines and financial media about taxes. Whether it’s what deductions you may be missing or simply a hate piece about how awful taxes are, I sometimes ask myself, “Do people even know how taxes really work?”

In fact, it’s extremely common for even very high-earning and otherwise financially successful people to not know a fundamental piece of tax information that, if better understood, would unlock the mystery of how income taxes work. 

The secret to having a reasonable understanding of income taxes is a firm grasp of how progressive tax rates work. Using a basic illustration, we’ll gain context of this sometimes-perplexing concept. 

A Brief Summary of U.S. Tax Rates

A tax system that is progressive applies higher tax rates to higher levels of income. The US has income tax brackets that range from 10% to 37%. This design leads to higher-income individuals or couples paying a larger share of income taxes than lower-income individuals or couples.

Here’s an example of how progressive tax rates may look (rates change every year):

Example Tax Rate Bracket Income Ranges
37%   $693,750 or more
35%   $462,500 to $693,750
32%   $364,200 to $462,500
24%   $190,750 to $364,200
22%   $89,450 to $190,750
12%   $22,000 to $89,450
10%   $0 to $22,000

Using this example chart, a married couple who files jointly who has a combined taxable income of $190,749 is in the 22% tax bracket. But what this really means to them requires a bit more explanation. To understand what it means to be in the 22% tax bracket, we must define some additional terms, effective tax rate and marginal tax rate.   

The effective (or average) tax rate is the percentage of your income that you actually pay in taxes each year; it’s an average or a ‘blend’ of the tax rates resulting from your total income applied to the corresponding tax brackets. Using the chart, a couple’s first $22,000 of income is taxed at the 10% rate, their income between $22,000 and $89,450 is taxed at a 12% rate, their income above that amount is taxed at 22% and so on. Thus, there are ‘bands’ of their total income that are taxed differently, or progressively, as you go up the brackets.  

The marginal tax rate is the amount of additional tax paid for every added dollar earned as income. For instance, our example couple with $190,749 of household taxable income is ‘in the 22% bracket’ but if they add one more dollar of income, that next dollar is taxed at 24%, that next dollar’s marginal tax rate.

So, a person may have an effective (or average) tax rate of 12% per year (paying 12% of their income in taxes) while having a marginal tax rate of 22% (they’re ‘in the 22% bracket’). In practice then, this means any decision they make that adds to their $190,749 income has a 24% tax owned on that next dollar.

Here’s where a lot of people are confused. Because their income may fall within the 22% or 24% tax bracket, they believe they’re paying 22% or 24% of their total income in taxes. To the contrary, our example shows that they’re actually paying only 12% of their total income in taxes after blending their income earned in the lower brackets with the income earned in the higher brackets.  

Why does this distinction matter?

As we consider the decisions that any of us may make as we save for retirement or head into retirement, we can control where we invest, from which accounts we draw money from, and to an extent, how much our taxable income is. We certainly can’t control the tax brackets and tax rates issued by the IRS, but we can control how we manage our own finances within that system. And some of what we can do to control our behaviors in the tax system are part of the retirement planning process. 

We may not be able to choose the tax system we’re in, but we can choose how we navigate it. And when we consider that the next decision we make concerning our finances can have a 22% or 24% or a 37% impact, it pays to have a strategy. It literally pays.