The Crazy Thing About Taxes

Those daily $3 coffees are not the root of your money troubles.

Personal finance is mostly about the big stuff. The house you buy, the car you drive, the student loans you take out—these are the things that can move the needle, for better or worse.

Taxes fall into this category, too. Yet no one seems to know what their tax rate is, which is kind of crazy.

A lot of people use TurboTax, it spits out a number, and they get a refund. Others hire an accountant, he spits out a number, and they get a refund. Either way, all they care about is the refund.

After Trump signed the Tax Cuts and Jobs Act into law in 2017, the Treasury Department changed the tax withholding tables. So people had less money withheld from their paychecks, and they got smaller refunds as a consequence.

The uninformed masses assumed their taxes had gone up because of the smaller refunds. Folks on Twitter were calling it the Trump tax hike. Talk about bad marketing! In reality, their taxes had gone down, but they didn't notice because their refunds were smaller.

You do not want to be one of these people. Really, I think everyone should do their own taxes, at least for a while. So let’s take a look at the rates...

Know Your Tax Rate

The US has a progressive income tax, which means the higher your income, the higher your tax bill is supposed to be. This would still hold true if we had a flat tax, though, where everybody pays the same rate.

Say everyone paid 20% in taxes. But you made $100,000 a year, and your friend made $1 million a year. In that case, you would pay $20,000 in taxes and your friend would pay $200,000. So he’s still paying more, despite the flat tax.

With a progressive income tax, like the one we have, people in the top tax brackets pay exponentially more.

Okay, there's two key things you want to know: your marginal tax rate and your effective tax rate.

The marginal rate is the top rate you pay. For example, if you and your spouse make $125,000 a year combined, your marginal tax rate is 22%.

Your effective rate is the blended rate—the average of all the marginal income tax brackets that your income level includes. You can pinpoint your effective tax rate by looking at the “total tax” line on your tax return and dividing it by your adjusted gross income. That’s your effective rate.

Find Your Bracket

I imagine most of you have never looked up your tax bracket, so let’s walk through that, too. We’ll use rough numbers for 2019, married filing jointly.

From $0 to $19,400, you pay 10%, but there’s an asterisk on that. We’ll circle back to it in a moment.

Then you pay 12% on anything up to $78,950. This is the highest rate most people pay, given the average income in the country.

After that, you pay 22% on income up to $168,400. This covers all but that top 5% or so of taxpayers.

From there, you pay 24% on income up to $321,450. Then it jumps up a little bit: 32% on income up to $408,200... 35% up to $612,350... and 37%, the top marginal tax rate, on anything greater than that.

How This Works in the Real World

Say you and your spouse make $150,000 combined. The first $19,400 is taxed at 10%, the next chunk up to $78,950 is taxed at 12%, and the rest is taxed at 22%. So your top marginal tax rate is 22%, but your effective rate is somewhere in the neighborhood of 16%, which doesn’t sound that high.

Most people would consider $150,000 to be a lot of money. I mean, it’s not going to make you rich in New York City or Silicon Valley. But $150K puts you in great shape pretty much anywhere else in the country. And your effective tax rate is only 16%!

Now for the asterisk: This is all before any credits. It's before any deductions. So a lot of people end up paying much less than their effective rate.

One way to drop your tax bill even lower is to maximize the pre-tax contributions to your IRA or 401(k). Doing that lowers your taxable income and it puts you on track for the retirement you want—a topic I cover extensively in my special report, Saving and Investment for the Retirement You Want.

The Lamborghini Tax

Of course, none of this means I’m pushing for higher income taxes.

If you tax something you get less of it. With income taxes, high rates encourage people to work less. So I’ve never understood why we go about it this way.

Probably because no one cares what someone else has to pay. This is why far-left discussions about a 90% income tax flare up from time to time.

Economists have looked at this, and it’s the marginal tax rate that affects behavior. A 90% tax—even if that’s just the top marginal rate—would give people a strong incentive not to work, not to contribute.

A better alternative would be to tax consumption. It’s the conspicuous consumption that many people find offensive, not the income itself. If somebody buys a Lamborghini, and they have to pay a 25% sales tax, I don't think anybody would have a problem with that.

For now though, we’re stuck with a progressive income tax, and it can impact your personal financial health in a BIG way. So you need to know the basics we just covered.

Jared Dillian
Jared Dillian