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The most misunderstood thing about income taxes – The Motley Fool

No one likes to pay taxes, and only a few people fully understand all the nuances of the United States income tax system. As another tax season approaches, US taxpayers will have to grapple with the important new tax provisions in the framework of tax reform, and there will be a lot of confusion about the exact impact that changes in the size of invoices and reimbursements will have. of taxes.

However, there is something that has been in the income tax system almost since its inception a century ago that many taxpayers are still confused. It is common to refer to being in a particular tax bracket or paying a certain marginal tax rate, but many do not fully understand the implications in their general tax bill that these concepts have. This is an attempt to explain in simple terms what fiscal brackets mean, and why proposals that refer to changing the tax brackets often do not have the effect they seem to have.

Mosaic of a percentage sign in gold.

Image source: Getty Images.

The fundamentals of the fiscal sections.

The United States income tax system is progressive, which means that low-income taxpayers pay lower tax rates than high-income taxpayers. The way this is done is by charging certain tax rates for income ranges, called parentheses. For example, under current law, taxpayers pay 10% in income taxes on a certain amount of income, and then, above that, a higher tax rate of 12% is applied up to a second threshold. This continues upwards through a total of seven parentheses, reaching a maximum of 37%.

Tax groups get their names from the tax rate that applies to that group. Therefore, low-income taxpayers are generally in the range of 10% or 12%, while people with higher incomes are in the range of 37%. Another way of saying the same thing is that if it is in the range of 12%, then your marginal tax rate is 12%. This means that for the last dollar of income he earned, he paid a 12% tax rate.

The confusing of the brackets.

The hard part is that just because you're in a given tax range does not mean that everyone of your income is taxed at that rate. That is a common misunderstanding, because people get scared when their income approaches the top of the tax category. For example, the largest jump under the current tax law occurs between 12% support and 22% support. Some mistakenly believe that if you earn a single additional dollar that takes you up to the 22% range, it will cost you 10 additional percentage points in taxes for every penny of your income.

However, that is not the way fiscal sections work. The reason why it is called marginal tax rate is that the rate is applied only in the margin, that is to say, to the maximum dollar of profits that it obtains. All of the lower tax brackets on the road will remain in effect, and you will still benefit from the lower taxes on that income.

An example of how the fiscal sections work.

To see how this works, let's look at a single typical taxpayer in 2018. Say you had a taxable income of $ 38,000 last year. When you look at the 2018 tax brackets, you will see that with that income, you would be in the 12% tax block. Your total tax would amount to $ 4,369.50.

Now consider what happens if what many people fear really happens: a person gets an additional income that pushes him to a higher tax level. Taking the previous example, suppose you received a year-end bonus of $ 2,000. That would raise the total taxable income to $ 40,000, which would place it in the 22% range.

Some fear that this will lead to an automatic increase of $ 4,000 in taxes, because the 22% range is 10 percentage points higher than the 12%. But when you run the numbers, you will find that the total taxes owed are $ 4,739.50, only $ 370 more than the previous example.

Because the difference? The reason is that only a small part of their general income was taxed at the marginal rate of 22%, specifically the $ 1,300 that earned above the upper level of $ 38,700 of 12% support. The rest continued to enjoy the lowest tax rates of 10% and 12%.

Taxes do not have to be hard to understand

Misunderstandings like these can lead to great controversy. The recent proposal of Rep. Alexandria Ocasio-Cortez (DN.Y.) is a great example, since many confused the proposal to add a tax range of 70% for income levels above the $ 10 million that they have an impact on taxpayers of all income levels.

The most important lesson you can learn about the tax brackets is that the threat of a higher tax rate should not prevent you from obtaining additional income. By working with the mathematics involved, you can determine exactly how much additional tax you will pay, and that will show you that the tax brackets are much less sinister than they appear at first glance.

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