The tax code is so complex – and sometimes our math so specious – that we worry the IRS is about to come a-knockin’.
If you take a look at the table below, which displays tax rates for income earned in 2012, don’t freak if you notice you’re in the 25% bracket but you’ve paid maybe 18% of your income in taxes. The math isn’t as simple as that rate might suggest, because, again, the tax code is extremely nuanced.
We won’t go into the nitty gritty; instead, we’ll focus on the major building blocks for your effective tax rate: your bracket, your deductions and, for some, your non-salary income.
1) Your tax rate and your bracket
If this is your first time filing a tax return, you’re probably heard a lot about “tax brackets”. To identify your own, all you need is your total adjusted gross income: that’s your wages and salary plus any additional income, which you’ll find on a 1099 – more on that in the third section.
|Tax Rate||Single filers||Married filing jointly or qualifying widow/widower||Married filing separately||Head of household|
|10%||Up to $8,700||Up to $17,400||Up to $8,700||Up to $12,400|
|15%||$8,701 – $35,350||$17,401 – $70,700||$8,701 – $35,350||$12,401 – $47,350|
|25%||$35,351 – $85,650||$70,701 – $142,700||$35,351 – $71,350||$47,351 – $122,300|
|28%||$85,651 – $178,650||$142,701 – $217,450||$71,351 – $108,725||$122,301 – $198,050|
|33%||$178,651 – $388,350||$217,451 – $388,350||$108,726 – $194,175||$198,051 – $388,350|
|35%||$388,351 or more||$388,351 or more||$194,176 or more||$388,351 or more|
With that total adjusted gross income (AGI) and the corresponding tax rate, which you’ll find in the leftmost column of the table, you may be confused: “I paid that much in taxes last year?”
No, not really – you didn’t, unless you fall into that first bracket, with a 10% rate.
Let’s say you’re single and you made $40,000. Your bracket is indeed 25%, but you paid much less than that. You’d have paid about 15.08% – assuming you don’t claim any dependents and before any deductions or exemptions, which you’ll learn about in the next section.
The reason for this discrepancy, between your bracket and tax rate: What you actually pay is your effective rate. That number attached to your bracket? That’s your marginal rate, the percentage you pay on that margin, or group, of income.
In other words, if you look at the table and follow those two left-most columns, with the marginal tax rates first and the income ranges next, this will begin to make sense. The first $8,700 you earned was taxed at 10%. The next in earnings is taxed 15% – that’s the rate for all you earn between the 8,701st and 35,350th dollars, or a total $26,649 taxed at 15%. The remaining $4,649 is taxed at that marginal rate of 25%.
So, in total, you owed 15.08% to the federal government for 2012 income – not 25%. Don’t think the IRS is after you – not yet at least.
2) Deductions to your tax bill
15.08% still isn’t the overall effective rate. As we’d mentioned earlier, it’s the effective rate before any deductions or exemptions.
Such tax breaks will lower your tax bill, although the amount varies from person to person: it depends on your choice of deduction, either standard or itemized.
All are eligible for the former, the standard deduction, and it’s a flat amount. Here’s a list, by tax-filing status, for income made in the 2012 calendar year:
- $5,950 for single filers or married couples filing separately.
- $8,700 for head of household filers.
- $11,900 for married couples filing jointly.
Some will claim this standard deduction, while others itemize because they stand to reduce their tax bill substantially more: they catalog their tax-deductible expenses, list them, add them up and deduct a given amount from their tax bill. Generally, that deduction is the given expense multiplied by your marginal tax rate.
It follows that, if you spend enough dough, it’s prudent to itemize your deductions because you’ll save boatloads of money. The wealthiest of the wealthiest cut hundreds of thousands of dollars from their tax bill this way.
There are a number of other reductions to your tax bill, too: exemptions, credits and more. They also reduce your tax liability, and, unlike deductions, some benefit lower-income Americans most, like the Earned Income Tax Credit.
3) Additions to your tax bill: the 1099
You know now that you can reduce your tax bill substantially. You may also have to do the opposite: shell out more.
If you get Form 1099 in the mail, it means you have to report additional income on your 1040 – income that doesn’t neatly fall under the wage-and-salary umbrella. There are a number of 1099s, but the most common may be the MISC, for freelancers – hence why those workers themselves are sometimes called 1099s, too.
As independent contractors, they’re not really salaried employees, and so their income doesn’t qualify for the same rates as most people’s income.
Rather, they’ll pay more: the companies with which freelancers do business are not obligated to withhold on Social Security and Medicare; they don’t match contributions like they would for full-time employees. So, when it comes to those two taxes, the freelancer pays more.