Today’s fantastic family finance article is:
Ask your teen this money math question: “Let’s suppose you make $40,000 of taxable income. That puts you in the 25% federal tax bracket. How much income tax do you pay the IRS?”
You’re likely to hear some reasoning like: “Well, that means 25% of $40,000 which would be $10,000. Right?”
“Wrong. Try $5,793!”
Time to teach your teen how the progressive tax system works in the U.S.
The income you make is chopped into portions. The first portion is taxed at one rate — the lowest rate. The next portion is taxed at a higher rate. The next one a higher rate still. And so on. The ranges that define the sizes of each portion and the corresponding tax rates are known as tax brackets.
Here’s what the tax calculation looks like for our example:
|Tax Bracket||Income Portion||Tax Owed on Portion|
on first $0 to $9,225
on next $9,226 to $37,450
on next $37,451 to $90,750
The right-hand column shows the amount owed on each portion of income as each is taxed at a progressively higher rate. The total tax owed adds up to $5,793.
If we divide the total tax owed by the total taxable income of $40,000, we get 14.48%. That’s called the effective tax rate.
The rate in the highest tax bracket that applies to you is called your marginal tax rate. In this case, it’s 25%.
Key points to emphasize:
- You pay different rates on different portions of your income — not just one rate.
- Everybody pays the same tax rate on the first portion of income. Everybody pays the same higher rate on the second portion. And so on.
- The highest rate that applies is your marginal tax rate. That’s the one most people talk about.
- Your effective tax rate is typically quite a bit less than your marginal tax rate.
- You never "lose money" by earning more money and pushing yourself into a higher tax bracket.
If all that makes your kid’s eyes glaze over, you can always regress to the simpler Conan O’Brien tax lesson:
“Just taught my kids about taxes by eating 38% of their ice cream.”
Now you’ve got their attention!
Get tomorrow’s tip here.