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Do You Know How Tax Brackets Work?

February 15th, 2010
Income Tax Brackets Video

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I used to think that I could potentially take home less money if I was at the bottom of a higher income tax bracket. This video gives an example of two different people’s incomes to illustrate why that is not the case.

(Can’t view Flash? View the YouTube version.)

This is a Your Two Bits explanation of income tax brackets.

Have you ever wondered how exactly income tax brackets work? I used to think that if I was at the top of one bracket and got a raise that pushed me just barely into the next bracket, I could potentially bring home less money. I know I’m not the only one who has had this misconception, so here’s an explanation.

This table represents the 2010 tax brackets. Notice that your tax rate is affected by two main factors: how much you earn and how you file your taxes, such as single or married filing jointly.

For example, if you are married filing jointly and earn $137,300, you are probably a very hard worker or doing something illegal. You are also in the 25% tax bracket.

Does that mean that you pay 25% of your $137,300 in taxes, which is $34,325? No.

Let’s illustrate why, by looking at how two people’s incomes compare: Harold earns the maximum for the 25% bracket and Becky earns the minimum for the 28% bracket. That means Harold earns $137,300 and Becky earns one dollar more or $137,301.

Let’s first look at the taxes Harold will have to pay.

The first tax bracket is 10%. That means that on everything he earns up to $16,750, he would pay 10% in taxes. So for that portion of his income he would pay 10% of $16,750, which is $1,675.

Now let’s move on to the 15% bracket. Harold will pay a tax of 15% on everything he earns after the first $16,750 up to $68,000. $68,000 minus $16,750 is $51,250. So he will pay 15% of that $51,250 in taxes, which is $7,687.50.

Continuing on with the 25% bracket, we follow the same pattern, meaning Harold pays 25% on everything he earns after $68,000 up to $137,300. So he pays 25% of $69,300 which is $17,325.

Now we need to add all of the amounts from each bracket to determine Harold’s total tax liability or what he is responsible to pay—assuming he doesn’t want to go to jail. When we add all of these together, we get $26,687.50.

Notice that $26,687.50 represents 19.4% of Harold’s $137,300 income even though he is in the 25% bracket. It’s not as bad as a straight 25%, but it’s probably about $26,000 more than he would like to pay.

Now if Becky earns just one dollar more, she is in the 28% bracket. She would pay the same amount in taxes as Harold for the first $137,300—assuming she is not a tax evader—then she would also pay 28% in taxes on the $1 she earns that falls in that 28% bracket. This means she would owe an additional $0.28 in taxes, which makes her total tax liability $26,687.78.

You can see that Becky still brings home more money than Harold, even though she just barely falls into the next higher tax bracket. So while being in a higher bracket does mean a higher percentage of your income goes toward taxes, it does not mean that you will bring home less money.

Now that you understand how tax brackets work, you don’t have to be afraid of getting a raise. And that’s a Your Two Bits explanation of tax brackets.

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Capital Gains Tax Rates

April 22nd, 2009

Does anybody have to worry about taxes on capital gains right now? It seems most are worrying about capital losses. However, with the market so low compared to where it was last summer there is a decent chance that people who are currently investing (and likely buying low) will have reason to consider capital gains tax rates before they sell their investments in the future.

(Note, this assumes investments, such as mutual funds and stocks. Other types, such as real estate, have slightly different rates.)

2009 Capital Gains Tax Rates

Time Held
Tax Bracket
35%
33%
28%
25%
15%
10%
< 1 year (short-term)
35%
33%
28%
25%
15%
10%
> 1 year (long-term)
15%
15%
15%
15%
0%
0%

Basically, you pay your regular income tax rate, if you sell the the investment within a year of buying it. If you wait at least one year from the date of purchase, your tax rate drops significantly.

However, the law regarding these tax rates is set to end after 2010. At which time the tax rates would return to what they were up to 2003, which also includes a slightly lower rate for holding investments more than five years.

2011 Capital Gains Tax Rates

Time Held
Tax Bracket
35%
33%
28%
25%
15%
10%
< 1 year (short-term)
35%
33%
28%
25%
15%
10%
> 1 and < 5 years (long-term)
20%
20%
20%
20%
10%
10%
> 5 years (long-term)
18%
18%
18%
18%
8%
8%

Let’s hope that Congress votes to keep the rates low—better yet, let’s encourage them to do so.

That’s my two bits. What are yours?

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AIG Bailout and Bonuses

March 23rd, 2009

I don’t think AIG execs should be the scapegoats that Congress has turned them into. Of course, I also strongly disagree with how AIG has handled the bonuses. It doesn’t make sense to me that you would give people bonuses, when those people have not saved the company from bankruptcy; that’s where the company would be, if it weren’t for the bailout. And I think that’s where it should be. Our economy was in a credit bubble that collapsed. Why are we trying to sustain a bubble? Doesn’t that make for a very shaky foundation?

One of my biggest concerns with this situation is how riled up people have been about $1.65 million dollars worth of bonuses, which amount to about 1% of the total that the government (representing we the people) gave to AIG. Do we really think this is the only misuse and waste of taxpayer dollars that this and other bailout companies will cause? I think there’s a bit of blame that could be shared with our elected officials for so hastily passing such massive debt spending, without spelling out the stipulations. Interestingly there was some language about using the bailout money for bonuses, but that was removed before passing the bill.

Also, I don’t like the idea of coming up with ways to retroactively punish the company and its employees. I particularly don’t like that the House passed a bill trying to impose a tax on those employees. A lot of people will say, “But we can’t have them stealing our money.” I’m quite irritated by that as well; however, I’m quite concerned when I see our elected officials rousing the people into a mob-like fury against a small group of people.  The laws of our lands should be equitable for all. If we target this group this time, it sets a bad precedent. Then the next time somebody is doing something we don’t like, we just rile up the people and impose taxes or other forms of punishment on that group.

Rather than being so quick to punish these people who were not acting illegally (Irresponsibly? Yes, but not illegally), and implementing taxes that we would find extremely unfair if aimed at ourselves or other minority groups, we should make a ruckus and simply clarify how bailout money is to be handled going forward.

What’s interesting is that we are stuck with this company. In normal conditions, our disgust could be demonstrated by not buying the company’s product, causing it to fail or severely stumble. That would be a strong lesson to the company and other company leaders, helping them to avoid such poor decisions. However, in this case with AIG, because we have bailed them out and won’t allow them to fail, it will only cost us more as the government has to pump more money—our money— into the company to make up for people not wanting to do business with them. That means we end up paying twice for a product we don’t want.

There are problems all around with this AIG case specifically and plenty of blame to be shared, but my biggest concern is that we allow ourselves to become so focused on this one instance that we lose sight of the bigger long-term implications. Wouldn’t we be in much better shape, if we, including our representative government, behaved more responsibly with our money and kept in mind the defense of our fellow citizens, recognizing that allowing one group to be targeted makes defending another group more difficult?

All that being said, two good pieces of news are emerging: 1) at least a third of the bonus money is being returned, and 2) the tax bill that passed the House last week seems to be losing steam and likely won’t make it past the Senate.

I’ll readily admit that while I have followed this pretty closely I may have missed some important details and am open to additional insights others may have. Please share your two bits, so that we can learn and potentially avoid making such huge mistakes at the federal, state, and personal financial levels.

——-

After publishing this post, I ran across a post on the  Weakonomics blog that covered this same topic, with some additional interesting points. “AIG Bonuses Have You Pointing the Finger in the Wrong Direction.”

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Don’t I Lose Tax Benefits If I Pay Off My Mortgage Early?

February 12th, 2009

I think we have all heard that there are great tax benefits to home ownership, but is that accurate? For one, I’m not sure that you get any tax breaks for owning a home—at least not where I live. If you’re paying a mortgage, you do get a tax break for the interest you pay; however that means you don’t truly own your home yet.

I have heard people say they want to get into a home for the tax benefits. The problem is that the tax benefits aren’t that great. They don’t warrant buying a home, and they certainly don’t warrant never completely paying off the mortgage, which I have heard argued. To understand why, simply look at your income tax filings.

We recently did our taxes and paid over $6,500 in interest on our mortgage last year. Including that interest as a tax deduction in our tax filings made a difference on the taxes we owed. The table below shows the difference in what we would owe or get refunded based on whether we included the mortgage interest as a deduction.

With Interest No Interest
Federal $437 (refund) $410 (owed)
State $12 (owed) $567 (owed)
Total $419 (refund) $977(owed)

.
The difference between what we would pay with interest and without interest is $1,396, basically $1,400. In a sense, paying $6,500 in mortgage interest saved us $1,400 in taxes, but it’s really not even that good. Which sencario would you prefer?

  • Scenario A: Pay $6,100 ($6,500 in interest minus $400 tax refund—remember this is a refund of my own money)
  • Scenario B: Pay $977 ($0 in interest plus $977 in taxes)

I’d rather have the home paid for and pay the $977 in taxes.

So as you prepare your taxes this season or if the illusion of great tax benefits are factoring into your consideration of buying a home, look at the real numbers of what the tax benefits will mean. If you don’t have a mortgage, it’s easy to figure out how much you would pay in interest using the Excel loan amortization calculator I showed last week.

Feel free to share your two bits.

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