Understanding the American Tax Code

Part #1 Marginal vs Effective Tax Rate. 

Have you ever wondered why we were not taught about taxes in school?  It is safe to assume that the overwhelming majority of Americans have no idea what tax rate they pay. Below are the Marginal Tax rates in America, this is how we actually pay taxes. Marginal Tax means what percentage of tax you will pay on your next dollar earned. Effective tax rate is what percentage of taxes did you pay relative to all of your income. 

Let’s walk through this math, most people assume if you are the person making over $518,400 your taxes look like this-

Income $518,400

Tax rate x     .37

Equals $191,808 

This is NOT how our tax system works. The next dollar earned, marginal tax means that all people are taxed the same at each income level. You can’t pay 37% on your first $10,000  earned. The math works as following-

First $9,875 x .10 = $987

Next $30,250 x .12 = $3,630

Next $45,400 x .22 = $9,988

Next $77,775 x .24 = $18,666

Next $44,050 x .32 = $14,096

Next $311,049 x .35 = $108,897

Total taxes paid = $156,265 with an Effective rate of- 30% (156,265/518,400 = .30)

You might notice this misunderstanding is where you hear the line “If I make more I will go into the next tax bracket!” Only your next individual dollar will be taxed more. Imagine that, you make one more dollar and immediately the government takes and extra $10k, ridiculous! 

The key to remember is that everyone pays the exact same rate on their money, a billionaire pays the same taxes on their first $50,000 as you do, well unless they have a way to avoid taxes somehow…. Oh wait they do! 
The tax aversion conversation is for part #2, however let’s talk about effective tax rate. If you remember when Warren Buffett said he should have to pay more in taxes he made the claim that his effective tax rate was only 19% or less. How could this happen, isn’t the top tax rate 37%? Correct, however that is the top Income tax rate, billionaires don’t make income. They use the system to avoid fair taxation. Most of the ultra wealthy pay less of their total income as a percentage in taxes than the majority of working people. On part #2 we will dissect how billionaires avoid income tax.