One of the smartest people I know told me that if the tax rates go up, he and his wife were going to make sure that their income never went above $249,999.99 because he refused to pay the higher tax rates.
At first I laughed because I thought he was kidding, but after a second, I realized he was dead serious. He went on to say that he wasn't going to pay 39.5 percent on his income and since the threshold was going to be $250,000 it made sense to keep it below that level.
When I asked him what his marginal tax rate was, he said, "I'm in the highest tax bracket — that's all I know." I told him that although he might be in the 35% tax bracket (currently the highest bracket), his marginal tax rate was significantly less than that. Like many others, he finds it difficult to understand the concept of marginal tax rates and how they are applied to our income and the taxes we pay. Under the system of marginal tax rates, every time your income crosses the line into a new tax bracket, the rate rises only for income above that line.
It took me a while to explain marginal tax rates to him and I'm still not convinced that he fully understands the concept, but I think he accepts the fact that his 35 percent bracket doesn't apply to 100 percent of his income.
After this encounter, I searched the Internet for an easy way to explain marginal tax rates and found this concept duplicated on several sites. I think it's an excellent visual aid to understanding how our tax system works. If you, like many others, need instruction, class is now in session. Here's what you'll need:
Paper and pencil
Separate 100 pennies into five groups of 20 pennies each. Each penny will represent $1,000 of taxable income, so the whole amount represents a taxable income of $100,000.
Write out the following tax rate schedule:
0 to $20,000: 10 percent
$20,001 to $40,000: 15 percent
$40,001 to $60,000: 20 percent
$60,001 to $80,000: 25 percent
$80,001 and up: 30 percent
This represents the marginal tax rates for increasing amounts of taxable income. The actual tax brackets and cutoffs used by the IRS are different and change each year, but this schedule illustrates the concept.
1. So now you have five piles of pennies with 20 pennies in each. Looking at the first pile of 20 pennies, what should the rate be on taxable income of $20,000? The answer, according to the schedule, is 10 percent, or $2,000. Remove two pennies, representing $2,000, from the first group and set them in front of that group.
2. The second group of 20 pennies represents the portion of taxable income from $20,001 to $40,000. What is the tax rate on this portion? The correct answer is 15 percent. Remove three pennies from the second group, representing 15 percent, or $3,000, and set them in front of the group.
3. Don't get confused; remember the tax rate schedule above, look and see that the 15 percent rate applies only to the second $20,000 worth of taxable income. The tax rate on the first group of pennies remains the same: 10 percent.
4. Repeat these steps for the remaining three groups of pennies, removing four pennies (20 percent) from the third group, five pennies (25 percent) from the fourth group and six pennies (30 percent) from the last group.
Now add up the pennies removed from the five groups. The answer is 20 pennies, or $20,000. This illustrates the effect of marginal tax rates.
A person with a taxable income of $100,000 is in the 30 percent bracket but pays only 20 percent in taxes, because the 30 percent rate is what's charged on the "last dollar" earned, not the whole amount.
No one wants to pay more taxes than they have to, but understanding the concept of marginal tax rates and how your income is taxed might soften the blow a little.
OK, class dismissed!
Fred L. Goldenberg is a Certified Senior Advisor (CSA) and the owner of Senior Benefit Solutions, LLC, a patient & consumer advocacy and financial services organization in Traverse City. If you have any questions or comments about this article or any other senior issue, he can be reached at 922-1010 or firstname.lastname@example.org.