Foundations of Finance

Are taxes emptying your pockets?

Tax day is coming up quick, and the rush to get ready is beginning.  Everyone knows taxes can be very confusing to the average person – that’s why accountants get paid so much.  But there are some common misconceptions about taxes that could make a difference to you and your finances.  One of the biggest ones is tax brackets.

If you asked a random person out on the street what tax brackets are, they would probably say that the higher your income, the higher the percentage you have to pay in taxes.  That is partially true.  But because of this not-quite-accurate definition, many people misunderstand and say something like “I don’t want to have a higher income, because then I would be in a higher tax bracket.”  In fact, that is an awful strategy.

The way the brackets work is a little more complicated, but overall it costs less money than the previous definition would lead you to believe.  We have what is called marginal tax brackets.  This means that there are certain levels of income – kind of like platforms, or steps on a ladder.  The first “step” is at $16,700 right now.  All the money that you make below that amount is taxed at 10%.  The next “step” is $67,900.  All the money between $16,700 and $67,900 is taxed at 15%.  The money you earn that is higher than $67,900 but lower than the next step is taxed at the next highest percentage.  And the steps keep climbing.

This makes a big difference compared to the normal misconception.  For example, say that you make $16,701 in one year.  Under the first definition, you would have to pay 15% on all of it, which would come out to $2,505.15 total.  But under the marginal tax bracket, you would pay 10% on the first $16,700 (which equals $1,670) and 15% on the extra $1 (which equals 15 cents).  So instead of paying $2505.15 in taxes, you are only paying $1,670.15.  The marginal tax bracket system has saved you $835.

This system completely eliminates the need to stay under a certain tax bracket level of income.  Unfortunately, many people don’t understand, and their finances suffer because of it.  But now you know, and that fear of a “higher tax bracket” will never haunt you again.