A friend reminded me this past week of the story I tell on my website about my dad and taxes. “Don’t just file those away”, he said to me years ago. “Look them over and get an understanding of what’s going on”.
It was an early catalyst for discovering my love of personal finance.
Many folks feel overwhelmed by any talk around taxes. This is understandable. Our federal tax code can be a tough code to crack. It is a moving target of rules, income phaseouts and brackets which seem to change on a near constant basis.
Effective Tax Rate vs Marginal Tax Rate
We follow a progressive tax system in the US. This means the amount of tax we pay on the first dollar we earn is less than the tax we pay on the last dollar we earn. This progression results in a taxpayer’s Effective Tax Rate, or average overall tax rate, being less than their Marginal Tax Rate, or the tax rate of their final dollar(s) earned.
It tends to be a taxpayer’s marginal tax rate that is referred to most often, however it is the effective tax rate that more accurately reflects the average amount of tax you pay. When a taxpayer falls into the 24% tax bracket for example, this is their marginal tax rate…24%. This simply means that the highest level of tax paid was 24%, even if it was only $1 of income in that bracket. But their effective tax rate, the amount of tax they paid as a percentage of their overall income, is typically lower.
Total Tax Liability vs Amount You Owe
If you look at page 2, line 23 of your 1040 you’ll see “Amount You Owe”.
This is NOT your total tax liability for the year, which is up above on line 16, aptly named “total tax”.
Amount you Owe is what is still left to pay of your total tax liability for the year, unless of course, you are getting a refund.
Your total tax liability in any given year depends on many different factors. And even if the figure on line 16 is higher this year, it doesn’t necessarily mean you are paying more in taxes.
You have to take into account what percentage of your overall income that number represents, which as you read above, is your effective income tax rate.
Let’s compare apples to apples:
In 2018, I picked 100 apples and had to give 20% of them to Uncle Sam.
That’s 20 apples (Total Tax, line 16).
I paid in 1 apple each month for the year, so in April I owed 8 more apples (Amount You Owe, line 23).
In 2019, I picked 200 apples and had to give 20% of them to Uncle Sam.
That’s 40 apples (Total Tax, line 16).
I paid in 1apple each month for the year, so in April I owed 28 more apples (Amount You Owe, line 23).
Since 40 is more than 20, it would appear I owed more to Uncle Sam in 2019, and as a flat amount of apples I did, but as a percentage of my overall apple income, my taxes did not go up.
I owed the same amount as a percentage of my apple income…20%.
And since the amount I owed in April (line 23) was 28 instead of 8 this year, it may appear as if I owed more in 2019, but it’s because I didn’t pay enough apples each month along the way in 2019 (paycheck withholdings). Overall, I still paid 20% both years.
Now for purposes of simplicity in this example, I used a flat tax of 20% instead of a progressive tax that I explained up above. You may be thinking this would not happen, because if I picked more apples, I would have owed more than 20% this year. However, this example helps to demonstrate what the expanded tax brackets did for many Americans with the passing of the Tax Cuts and Jobs Act of 2017.
From 2018 through 2025, when this law is scheduled to sunset, many Americans can earn more while remaining in the same tax bracket, or in some cases a lower bracket, than they were in prior to 2018.
That sounds like a pretty good tax deal to me!