From The Mailbag: How Do Tax Brackets Work?

The new tax bill contains a lot of confusing stuff, especially if you don't already have a thorough understanding of how taxes work. One of the big provisions of this bill is a change to the "tax brackets." What does that mean?

Dear Kate,

I have read that my taxes are going to go down because of the new tax brackets?  Is that true?  What does it mean?

Ron

I can't answer Ron's question about whether his taxes will go down, because there are a lot more changes than just the tax brackets. But I can explain how tax brackets work.

Dear Ron,

Unfortunately, I can not predict what is going to happen to your individual taxes because your tax calculation includes so many things besides the tax brackets.  But I can explain that concept to you.

In America, your tax liability is calculated using "taxable income."  Taxable income is the number after you've made any adjustments to income, and deducted the standard or itemized deductions.  In the 2017 tax year (the taxes you'll do early next year,) this also includes the subtraction of personal exemptions, but those are eliminated under this new bill.

Our tax system is considered progressive, because you pay a higher income tax on higher amounts of income, and marginal, because you don't pay that higher income tax on all your income, just the income that is higher than the cut-off.

To give you a super-simple example, let's say our tax laws said: You'll pay 10% on your first $10,000 of income, and 15% tax on all income over $10,000.

Here's how that would look as a "tax bracket:"

And applied to actual income, it would work out like this:

As you can see, folks who are earning more than $10,000 are still paying 10% on their first $10,000 of income. They only pay the higher tax rate on the income that exceeds the cut-off.

Please note how it is phrased in the tax bracket versus how it works out in the chart that shows how you get to the results. Tax bracket charts typically use a short-hand to explain the math done at the lower tax brackets, just explaining the amount you'll pay for all income under and over a certain cut-off. It looks more confusing than it is.

Now let's try it using actual tax brackets from the new tax bill. This tax bracket is for married filing jointly. For someone with a taxable income of $78,000, the language in the tax bracket says:

"Over $77,400 but not over $165,000 ........ $8,907, plus 22% of the excess over $77,400."

Here's how that works out:

If you add up the taxes in the two different ways of doing it, it comes out the same: $9,038.78.  $8,907 is the tax for all the income up to $77,400, plus 2% of the amount over that. What the short version doesn't show clearly is how the lower income is taxed at the lower rates.

So, when you see a tax bracket chart, you're expected to magically understand that you're not paying that top tax rate on all your income. You have income being taxed at each of the rates up to your top tax rate. 

I hope the explanation, rather than the legal-ese, helps!

Kate

Did that help at all, or just make things more confusing?  Let me know, and I'll see what I can do to answer your questions.