The tax code is one of those things that never seems completely clear. You may know that there are different tax brackets, but you’re not sure how that affects what you pay each April. Add in the talking heads (particularly during an election year) spouting off about the effective tax rate of various politicians, and it can leave many of us scratching our own heads.
In order to understand your effective tax rate, you need to know how income tax is calculated:
Graduated Progressive Tax System
The American tax system is set up so that (theoretically) the burden of taxes goes up incrementally as incomes go up. This is what happens when you graduate from one tax bracket to the next.
Many people don’t understand, however, that graduating to the next tax bracket does not mean that you will pay the next bracket’s tax percentage on all of your earnings.
For example, an individual earning $40,000 per year is in the 12% tax bracket. If that individual were to be offered a $2,000 raise one year, he would then graduate into the $41,775 – $89,075 tax bracket, which pays 22%.
At first glance, it may seem as though the tax-payer might be better off without the raise, but that’s simply not true. He’ll continue to pay 12% on everything he earns up to $41,775, and 22% on anything above that, until he reaches the next tax bracket.
His tax increase is an increase on the amount earned over the bracket—in this case, on only $225 of his earnings—not on everything earned.
The fact that our system is based upon graduated progressive tax (brackets) means that no one can look at their income and say: “I will pay 20% this year.”
Here is a chart for current marginal tax rates:
| 2022 Marginal Tax Rate | Single Individuals Taxable Income Above | Married Filing Jointly or Qualified Widow(er) Taxable Income Above | Head of Household Taxable Income Above | Married Filing Separately |
|---|---|---|---|---|
| 10% | $0 | $0 | $0 | $0 |
| 12% | $10,275 | $20,550 | $14,650 | $10,275 |
| 22% | $41,775 | $83,550 | $55,900 | $41,775 |
| 24% | $89,075 | $178,150 | $89,050 | $89,075 |
| 32% | $170,050 | $340,100 | $170,050 | $170,050 |
| 35% | $215,950 | $431,900 | $215,950 | $215,950 |
| 37% | $539,900 | $647,850 | $539,900 | $323,925 |
Effective Tax Rate
Determining your effective tax rate is a fairly simple calculation to make, because it just takes the amount you paid in taxes and divides it by the amount you earned that year. For example, if the individual making $45,000 paid $7,500 in taxes, his effective tax rate is about 16.67%, even though he paid in the 12% and 22% brackets. However, you can only figure out your effective tax rate after you’ve paid taxes.
The effective tax rate was what Warren Buffett was referring to when he stated that his secretary paid higher taxes than he did. It’s common for many investors such as Warren Buffet to earn much of their income through long term capital gains, which are taxed at a flat rate, based on your income. Long-term capital gains taxes range from 0% – 20% based on your total taxable income.
Previously, long-term capital gains were taxed at a flat 15% rate, which is often lower than the tax rates earned by salaried workers whose salary falls into the graduated tax brackets as mentioned above.
Here are the current Capital Gains Tax rates:
| 2022 Long-Term Capital Gains Tax Rate | 0% | 15% | 20% |
|---|---|---|---|
| Single Filers | $0 - $41,675 | $41,675 - $459,750 | Over $459,750 |
| Married Filing Jointly | $0 - $83,350 | $83,351 - $517,200 | Over $517,200 |
| Head of Household | $0 - $55,800 | $55,801 - $488,500 | Over $488,500 |
| Married Filing Separately | $0 - $41,675 | $40,401-$258,600 | Over $258,600 |
| Trusts & Estates | $0 - $2,800 | $2,801 - $13,700 | Over $13,700 |
As you can see, there is an incentive to earn money through capital gains, which are often taxed at an attractive rate compared to income earned from your day job.
Due to a large number of tax breaks, deductions, credits, and exemptions, the very rich can find ways to reduce their taxable income, and thereby reduce their effective tax rate. Additionally, the very rich can also afford to pay accountants to find and take advantage of all of these opportunities and loopholes—which means that middle and lower-income taxpayers either need to become accountant-level experts in the tax code, or resign themselves to paying more to just to get done with filing.
Taxes and Fairness
The graduated progressive tax system is an attempt to spread out the tax burden so that those who are earning more money carry more of the burden, allowing low-income workers to keep more of their money to take care of themselves.
But calculating the effective tax rate that individuals pay shows that there are big flaws in the system—a system where Warren Buffett’s secretary pays a higher effective tax rate than her boss.
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Carl Lassegue says
I think the idea of having a graduate progressive tax system is a really good idea and I don’t think that part of the tax code is the problem. What do you guys think of the Buffet Rule? For or Against?
Andy says
I am fortunate enough that with my day job and side gigs I am in a higher tax bracket. Unfortunately this means I get hit with AMT as well! That’s one nasty surprise our progressive tax system really needs to deal with.