An often quoted CPA analogy to help explain tax principles is visualizing different buckets filling up with your income to define which tax rate you will pay. Understanding the difference between our marginal and effective rates will help us make better decisions regarding tax planning. Before learning different tax strategies we have to understand this principle. You can see the different tax brackets here.
Assume that each marginal tax bracket (e.g. 10%, 15%, 25%, 33% etc.) is a separate bucket. Our initial income always fills out the first bucket, 10%. For a Married-Filing-Jointly (MFJ) filer, the amount taxed at 10% in 2015 is $18,450. Once our income moves us into the next tax bracket, in this case, 15%, we are only taxed 15% on amounts above the $18,450. All taxable income is not now taxed at 15%. This is important because we don’t lose the benefit of filling up a low rate bucket first. Our first bucket remains full (taxed at 10%) and then the next bucket at 15% is filled. Once that bucket is full (when income reaches $74,900), another bucket (25%) is filled, and so on.
A common misconception is “I thought my entire income was taxed at my tax bracket rate.” This is not true. That’s why our tax system today is called a “Stepped-Tax” system.
To illustrate this, see the hypothetical example below:
Ricky and Lucy work in a chocolate factory, they are MFJ filers and have $92,000 in taxable income (income after deductions). Their money will be in three different income tax buckets.
The first bucket (10%) holds the first $18,450. The next bucket (15%) holds $56,450 which brings the total income to be ($18,450 + $56,450) $74,900 which is the threshold you will see on US tax tables for the 15% tax bracket. The third bucket (25%) holds the remaining $17,100. The total tax due is $14,588, barring any tax credits as shown above. Their effective tax rate is a combination of all three rates, or, ($14,588/$92,000) = 15.9%.
All tax planning decisions rest upon the principles of how the US Tax Brackets/Buckets are set up. When we are discussing tax strategies regarding investments, the effectiveness of the strategy often relies on the tax bucket that a person is in.
In the example above, Ricky and Lucy’s marginal rate (or tax bracket) is 25%. Another dollar of income would be taxed at 25% until that bucket is full (and then move on to the next empty higher bucket). Furthermore, another dollar of deduction would save them a dollar of income being taxed at 25% until that bucket is empty (and then move on to the next lower full bucket). This means if you are in the 15% tax bracket, every dollar deduction saves you 15 cents in taxes. While if you are in the 35% tax bracket, you save 35 cents. Both are benefits, but you can see how knowing this is important to understand when making decisions!
Our clients at Veater Financial Group benefit from tax planning being a part of their regular review schedule. Please feel free to call in with any additional questions.
Content in this material is for general information only. Examples shown are hypothetical for illustrative purposes only. Individual results will vary. Tax laws and provisions are subject to change. LPL Financial representatives do not offer tax advice or services. We suggest that you discuss your specific tax issues with a qualified tax advisor.