Understanding Your Tax Rate

Understanding Your Tax Rate

Welcome to the official blog of Brittany Lanphier, managing partner of Lanphier LLP based in Denver, Colorado!

Any tax guidance in this blog is intended for informational purposes only and is not guidance on which Lanphier LLP intends for you to rely. All tax issues specific to your business or family are largely facts-and-circumstances based and you should consult your tax advisor (or Brittany directly) to discuss how this might relate to you.

May 8, 2012

Well, free at last, free at last!  We have survived tax season over here at Lanphier Accounting!  There were times that it seemed questionable, but we did finally make it to tax day and get everything filed and finished.  Once again, we had a great tax season and were pleased in the significant growth in new clients as well as the high retention rate we maintain with our existing clients.

Since I didn’t spend tax day in labor this year, Dennis and I managed to get away for a much-needed and well-deserved (if I do say so myself) Caribbean vacation.  Although we had grand aspirations of getting off the resort and exploring, we found ourselves mostly relaxing in comfy beaches chairs and watching the waves roll in.  Two businesses and one (very active) baby have made prolonged periods of relaxation scarce for us this year, so it was truly a blessing to have that time to ourselves.

Speaking of Brooklyn, she had her own little vacation in Dallas with her grandparents while we escaped to Jamaica.   She had a blast and was probably missed way more than she missed us.   She has quite the fan club going down in Texas.   As you can see here, she inherited her mom’s love for shopping and thoroughly enjoyed being spoiled by her grandmother.

Understanding Your Tax Rate

This tax season, I heard quite a few questions about how our country’s tax rates function and realized that there is fairly wide-spread understanding on their mechanics.  I wanted to briefly explain the difference between your “marginal tax rate” and your “effective tax rate” and why this is important.

Most people understand that we have a “progressive” tax system in the U.S., which essentially means that the more money you make, the higher your tax rate.   Here are the tax rates that are applicable for 2012:

Tax Brackets 2012     Single                              Married Filing Jointly               Head of Household
10% Bracket               $0 – $8,700                   $0 – $17,400                              $0 – $12,400
15% Bracket               $8,700 – $35,350         $17,400 – $70,700                    $12,400 – $47,350
25% Bracket               $35,350 – $85,650       $70,700 – $142,700                 $47,350 – $122,300
28% Bracket               $85,650 – $178,650    $142,700 – $217,450                $122,300 – $198,050
33% Bracket               $178,650 – $388,350  $217,450 – $388,350               $198,050 – $388,350
35% Bracket               $388,350+                     $388,350+                                  $388,350+

Your “marginal tax rate” is where you fall in the above table.  Simply put, your marginal tax rate is the rate that will apply to your next dollar of income.  Therefore, if you are a single individual that makes $60,000 a year, your marginal tax rate is 25%.

There is a big difference between this individual’s marginal tax rate and his effective tax rate, however.  This is where I find that most of the misunderstandings lie.  Just because the above individual makes $60,000 a year does not mean that he pays 25% on all of his income.  As the tables might suggest, his first $8,700 is taxed at 10%, the next $26,650 is taxed at 15%, and only the last $24,650 is taxed at 25%.  Therefore, this individual would have an “effective tax rate” of 18.4% rather than 25%, because most of his income is being taxed at the lower tax brackets.

This example is a little overly simplified, because we aren’t factoring in any deductions or credits.  All of these tax rates are applied to your taxable income, which is calculated after applying your deductions and exemptions against your gross income (wages, investment income, etc).  Therefore, an individual with gross wages of $60,000 (and no other income) would likely have an effective tax rate much lower than 18%.

The main point I am trying to illustrate is that earning more income does not mean that ALL of your income is taxed at higher rates.  I receive this question a lot from married couples who earn disproportionate income.  One spouse may have a high paying job, while the other spouse stays home with the kids and works part-time.  These couples often worry that the second spouse going back to work will cause the first spouse’s high earnings into a higher tax bracket.  This isn’t the case.

As an example, lets say that Brad and Angelina are married.  Brad makes annual taxable income (after deductions) of $215,000.  If Angelina made no income, they would be in the 28% marginal tax bracket.  If Angelina gets a part-time job that pays $20,000 a year, they would move up into the 33% marginal tax bracket, meaning that most of Angelina’s dollars will be taxed at 33%.  This does not mean, however, that any of Brad’s dollars are being taxed at 33%.  He is still benefiting from the lower tax rates that apply to their income under $217,450.  Angelina does not need to fear that her relatively small earnings (by comparison to Brad’s) are hurting the family by forcing them into a higher tax bracket.

As usual, this is a gross over-simplification.  A tax return for married couple does not distinguish whose income is whose and what tax rates apply to that income.  We could just as easily say that Angelina’s dollars are being taxed at the lower rates, rather than Brad’s.  But this is an example that I see regularly, where one spouse has been the primary bread-winner and the other spouse fears that any additional work they do will be damaging to their tax position as a whole.

I hope that was a helpful synopsis.  Please feel free to call us for a consultation if this raises any further concerns or questions for you.

Until next time…