Meet Max. Max is an unmarried tax filer with no children. He’s a simple man with a simple income tax story. And it goes like this:
Max makes $50,000 per year at his job. For now, let’s ignore details like withholding, deductions, and whether or not he finds his work fulfilling.
When Max receives his W-2 form, it reports that he earned $50,000 of wages in 2018. So he’s on the hook for that amount. This is his total income.
Meet the Standard Deduction
But wait! Max can subtract $12,000 from his taxable income. In fact, most U.S. taxpayers can subtract $12,000. This is the standard deduction.
“$12,000 of tax-free income? Amazing!”
You gotta love $12,000 of tax-free income, courtesy of the standard deduction. And if Max were to get married, he and his spouse’s combined standard deduction would be $24,000.
Look at it this way: If Max only made $12,000 at his job, the standard deduction would zero out his taxable income. In that case, Max would pay nothing in federal income tax!
But luckily for Max, he earned $50,000, not $12,000. So let’s get back to the story of his simple tax return.
Max prepares his tax return and enjoys the standard deduction very much. Like magic, his $50,000 turns into $38,000 of taxable income. And that becomes the amount he’ll pay tax on.
Meet the Tax Brackets
Next, Max needs to determine how much tax he’ll pay on his $38,000 of taxable income. For that answer, it’s time to introduce the tax brackets.
“More like Max brackets! Am I right?”
Good one! Anyway, the table below shows the 2018 tax brackets for individuals—that is, anyone who’s not married. And that includes Max. Married couples are subject to a different set of tax brackets.
|10%||Up to $9,525|
|12%||$9,526 to $38,700|
|22%||$38,701 to $82,500|
|24%||$82,501 to $157,500|
|32%||$157,501 to $200,000|
|35%||$200,001 to $500,000|
Notice how the percentages increase on higher amounts of income. This is a progressive tax system. So the more income Max has, the more that additional income is taxed. That’s how we do it in the United States.
Anyway, the tax brackets define how much tax Max must pay on different parts of his 2018 taxable income.
The percentages in the first column don’t change unless there’s a change in the tax law, as there was recently. But the taxable income amounts in the second column adjust each year for inflation.
Remember that Max’s taxable income is $38,000 after the standard deduction. Now let’s apply that amount to the tax brackets, one part at a time.
Meet the Total Tax
According to the tax brackets, Max pays 10% on his first $9,525 of taxable income. That’s $952.50 of income tax.
But Max still has $28,474 of income he needs to pay taxes on ($38,000 – $9,525). That remaining amount is taxed at the next rate, which is 12%.
So, Max pays 12% on $28,475, which is another $3,417 of income tax.
Max’s total income tax is $4,369.50 ($952.50 + $3,417). This number is more important than how much Max owes or has refunded when he files his taxes. When everything shakes out, this is how much he paid in federal income taxes in the calendar year.
Meet the Tax Rates
If we divide the tax Max paid by his income ($4,369.50/$50,000), we learn that Max paid 8.79% on his $50,000. This is called his effective tax rate.
Don’t confuse this with marginal tax rate, which is the tax on each additional dollar earned. Max’s marginal tax rate is 12%. So if he earned $50,001, that extra $1 would be taxed at 12%. Bye-bye, 12 cents.
“Does that mean Max pays 12% tax on all his income?”
Not all of Max’s income is taxed at his marginal rate. Remember that $12,000 of his income is tax-free, thanks to the standard deduction. Then $9,525 of his income is taxed at 10%. Finally, the remaining $28,474 of income is taxed at his marginal rate of 12%.
If we slice Max’s total income into a delicious pie chart, it looks like this:
An effective tax rate of 8.79% seems harmless on the surface. But $4,369.50 of total tax is a lot of money to Max. It’s a big, ugly, annoying number, even if it doesn’t look so bad when it’s spread across paychecks. It would be nice if Max could somehow avoid some of this tax.
Taxes can—and do—get way more complicated than this scenario. But the good news is there are many legal ways to pay less tax that aren’t very complicated. It’s important to know how you’re taxed, and how much you pay, so you can make informed decisions to avoid tax. That’s what this series is about.
In Part 2 of this tax series, we’ll look at Max’s pre-tax deductions. And we’ll explore how he could lower his total tax with some basic tax avoidance techniques.
Disclaimer: The author is not a tax professional and is not providing tax advice. Do your own research and talk to a professional before making any tax moves.