How do taxes work?
If you watch the news, you’ve heard politicians argue about tax rates. Republicans argue that tax rates are too high, Democrats want them to be higher. They throw around high tax rates as if everyone’s going to be subject to them, which is definitely not true. In fact, most of the time when you hear a tax rate discussed, it applies only to a very small percentage of top income earners, while the rest of us pay a much lower rate.
The most important thing to understand when it comes to tax rates is that your taxes are calculated using a series of income “brackets”, each of which is taxed at a different rate. The lowest part of your income is taxed at a low rate, and as you earn more and more, the next “chunks” of your income are taxed at progressively higher rates. Sound complicated? It’s easy to understand once you learn the basics. The easiest way to explain it is through some examples.
Let’s go through some sample income calculations to illustrate the difference between a simple, flat tax and the more complicated bracketed system we use in the US. In these examples, we’re using only three brackets to make it easier to understand (in reality there are seven in 2018), and showing examples for three different income earners.
Flat tax is the simplest way to assess taxes, and it’s the method many Americans mistakenly believe we use. In a flat tax system, your taxable income is multiplied by a tax rate to calculate the amount of tax owed. Flat tax results in everyone paying the same tax rate; switching from our current bracketed system to a flat tax system would lower overall taxes for higher earners, and increase taxes for lower earners.
Example of tax calculation using a flat tax rate system (tax rate of 30% for all income)
- For income of $25,000: $25,000 x 0.30 = $7,500 tax owed
- For income of $100,000: $100,000 x 0.30 = $30,000 tax owed
- For income of $1,000,000: $1,000,000 x 0.30 = $300,000 tax owed
In this system, everyone is subject to the same tax rate, 30%.
Bracketed Tax Rates
Tax “brackets” refer to income ranges. For each range, a different tax rate applies, starting with low tax rates that increase as income increases. Bracketed tax systems like ours result in everyone paying a different overall tax rate, with lower income earners paying a lower rate, and higher earners paying a higher rate.
Example of tax calculation using a bracketed tax rate system (tax rate for first $30,000 of income: 10%; tax rate for $30,000 to $80,000 of income: 30%; tax rate for income over $80,000: 40%)
- For income of $25,000: $25,000 x 0.10 = $2,500
- For income of $100,000: $30,000 x 0.10 = $3,000; $50,000 x 0.30 = $15,000; $20,000 x 0.40 = $8,000; total taxes owed: $31,000
- For income of $1,000,000: $30,000 x 0.10 = $3,000; $50,000 x 0.30 = $15,000; $920,000 x 0.40 = $368,000; total taxes owed: $386,000
Note that in a bracketed tax system, each of these example taxpayers is paying a different overall tax rate: for $25,000 in income, the tax rate is 10% (2,500 ÷ 25,000). For $100,000 in income, the tax rate is 31% (31,000 ÷ 100,000). And for $1,000,000 in income, the tax rate is 38.6% (386,000 ÷ 1,000,000).
Understanding US Tax Brackets
If you’ve made it this far, you really care about taxation!
In all the examples above, the tax rates were simplified example rates. In 2018, there are actually seven tax brackets: 10%, 12%, 22%, 24%, 32%, 35% and 37%. The brackets for these depend on which earning structure you belong to (marital status, whether you’re filing as an individual or jointly (married), whether you’re head of household, and if you’re a qualifying widow/er with dependent child). Here are the income brackets for the two most commonly used filing statuses:
|Rate||Individuals||Married Filing Jointly|
|10%||Up to $9,525||Up to $19,050|
|12%||$9,526 to $38,700||$19,051 to $77,400|
|22%||38,701 to $82,500||$77,401 to $165,000|
|24%||$82,501 to $157,500||$165,001 to $315,000|
|32%||$157,501 to $200,000||$315,001 to $400,000|
|35%||$200,001 to $500,000||$400,001 to $600,000|
|37%||over $500,000||over $600,000|
Hopefully, this gives you a basic understanding of how our bracketed tax system works. Now understanding how to figure out how much tax you pay, and what your tax rate is, should be easier to make sense of.