“Where," you are thinking, “does Joe get the audacity to think he can explain taxes in a few sentences?"
Good question, but stick with me. The key word here is “basics”. I believe that if you can understand three concepts: Federal Tax Brackets, Standard Deductions and Personal Exemptions, you can understand the basics of our Federal Income Tax System.
Federal Tax Brackets
Almost everyone knows that there are such things as tax brackets, but few understand how they work. Most have this fuzzy notion that if more income moves us to a higher bracket, all of our income is taxed at a higher rate, thus costing us money. You may have heard someone bemoan, “I got a pay raise, but I will end up with less money because it bumped me into a higher bracket.” This thinking, besides being a disincentive to ambition and productivity, is simply wrong. Let me assure you that with our current tax system, it is impossible to lose money by making money. In fact, even the very wealthiest will pay no more than 35% of their earnings.
We have a progressively bracketed tax system which, in 2009, works thusly for married couples filing jointly: the first $16,700 of taxable income is taxed at 10%; the next $51,200 is taxed at 15%; the next $69,150 is taxed at 25%, the next $71,800 at 28%, the next $164,100 at 33% and everything above that is taxed at 35%. Whether a couple earns $5,000,000 or $5,000 these same brackets apply. It is that simple.
The standard deduction is the amount you are allowed to deduct from your adjusted gross income before the first bracket kicks in. For 2009, the standard deduction is $11,400 for married filing jointly or $5,700 for single or married filing separately.
You are also allowed to deduct a personal exemption of $3,650 for the taxpayer, spouse and each allowable dependent in the household. This deduction, like the standard deduction, is subtracted from the adjusted gross income before any taxes are applied.
Putting it Together
Our hypothetical family, consisting of a married couple with one child, earns $40,000 in 2009. The first $22,350 this couple earns is not taxed a single penny. Where did I get the $22,350? By adding the standard deduction of $11,400 to $10,950 (three personal exemptions at $3,650 each). Their taxable income, therefore, is everything earned over $22,350, or $17,650 ($40,000 less $22,350). Are you with me so far?
Now let’s figure the taxes this couple will pay on this $17,650. The first $16,700 is taxed at 10% (see Federal Tax Brackets above) for a tax of $1670. The remaining $950 ($17,650 – $16,700) is taxed at 15% for a tax of $142.50. Their taxes are therefore$1670 plus $142.50 for a total of $1812.50.
Now, before you bombard me with “what if" scenarios, I want to reiterate that the purpose of this post is to explain the basics of our Federal Income Tax system. These are the basics and you must admit they are pretty simple.
Footnote 1: You, like me, may be surprised to learn that, when comparing tax rates by country, many nations have higher rates than the United States
Footnote 2: My wife just read this post and said, “For the first time in my life, I ‘get it.'” Success!