When people come to my San Rafael office to go over their books, one thing I always try to explain is that my goals focus on clean, thorough, and accurate books. By doing so, I ensure that their records can help us Accounting professionals get them into a lower tax bracket. Thus, our company’s job as a your bookkeeper is to verify everything’s in order and accounted for as a first step in this process. In other words, it’s all about that tax bracket — and climbing down the ladder.
Marginal Tax Rate, Effective Tax Rate, & Other Key Terms
Usually, they smile and nod — they’ve probably heard of a tax bracket before, and the idea of a lower anything sounds good when it comes to taxes (except for your return, you want that as high as possible). But most clients don’t know much about tax brackets other than the actual term.
So what is a tax bracket? And why is it so important? Let’s take a closer look.
Everything You Need to Know About Tax Brackets
Taxable income is broken up into escalating categories known as brackets. Brackets represent a range of incomes, and for each bracket, there are a few different key terms involved:
- Tax Rate: Each bracket comes with a different tax rate. The lowest rate is at the smallest tax bracket, and the rate escalates as the bracket total increases. Technically, there are two different types of rates, a marginal tax rate and an effective tax rate.
- Cutoff Point: The base number of a tax bracket. Even one dollar over the cutoff point means you’re in the next tax bracket.
- Marginal Tax Rate: The basis percentage for each tax bracket is considered the marginal tax rate. This is a base number for each bracket plus a certain percentage of income over the bracket cutoff point, creating a progressive structure.
- Effective Tax Rate: The effective tax rate is the term given to the percentage of the actual tax owed compared to the taxable income. As the system is a progressive structure, nearly everyone has a unique effective tax rate.
- Taxable Income: Your tax bracket rate is based on taxable income, which is your income after all deductions have been calculated. Our job as a your bookkeeper is based on organizing records so that a we can lower your taxable income through deductions as much as possible.
- Filing Status: Tax brackets differ based on whether you’re filing as single, married but separate filing, and married with joint filing. Tax brackets are not a simple two-to-one escalator for married couples, so it’s important to know where you stand.
- State Taxes: 43 states have an income tax in addition to the federal tax rate. The structure for these vary, but many use a progressive bracket system similar to the federal one.
- Flat Tax: While this doesn’t necessarily apply, the idea of a flat tax rate is something that is debated in political arenas. A flat tax means a consistent rate for everyone, regardless of income level.
- Universal Sales Tax: Another idea discussed by politicians and lobbyists is the universal sales tax — that is, putting a universal high tax on all goods purchased while eliminating income taxes altogether.
Current tax rates and brackets are available online, and in fact, the 2018 tax brackets and rates were recently announced as of the time this post went live.
Example: Calculating Tax Rate
Now that we’ve gone over the basic terminology, let’s look at an example of calculating tax rate. For most people, this is the best way to understand the mechanics of getting to the final number. In our example, we’ll assume that Max and Fran are filing jointly as a married couple starting with these numbers:
- Combined gross income: $135,000
- Total deductions: $10,000
If this couple filed straight without calculating any deductions, they would fall under the fourth-highest tax bracket in 2017 ($131,200 to $212,500). This tax bracket has a marginal tax rate of $27,052.50 plus 28% of anything over the cutoff point of $131,200. Because there starting point is $135,000, the total over the cutoff point is $3,500. Thus, their amount of tax owed is $27,052 plus $980 (28% of 3,500) for a final amount of $28,032. Their effective tax rate is 20.7% (the percentage of their total gross income.
Now let’s see the difference when deductions are involved. By removing $10,000 due to deductions, the couple’s adjusted gross income is now $125,000. This moves them down to the third-highest tax bracket in 2017 ($50,800 to $131,200). The new marginal tax rate is $6,952.50 plus 25% of anything over the cutoff point of $50,800 — in this case, $74,200. After crunching the numbers, Max and Fran owe a total of $25,502.50 based on a calculation of $6,952.50 plus $18,550 (25% of $74,200). The new effective tax rate is 20.4%.
Thus, with deductions, Max and Fran were able to save about $2,500 in what they owed, and their effective tax rate dropped about ⅓ of a percent.
Other factors apply, such as tax credits for children or other situations or capital gains/losses. For simplicity’s sake, let’s omit these things for now. We’ll ignore state rates for now too, but if we go with the assumption that Max and Fran are living in California, they will have to make a similar calculation for the state income tax.
How to Get to a Lower Tax Bracket
What’s the best way to get to a lower tax bracket? One word: deductions. Deductions come in many forms, and it depends on your home and work situation. But the only way to clearly calculate the complete potential behind your tax deductions is to track all of your receipts and spending for a calendar year. The good news is that technology has changed how we can handle such a task. In the old days, that means folders or shoeboxes of receipts, along with a lengthy few days of cataloging and categorizing. Today, there are many easier and faster methods.
First, most credit card companies now auto-categorize transactions to give you a head start. If you use a card for most of your purchases (this is a good idea in general because it gives you fraud protection, in addition to card rewards), then a good amount of your work is already done. Second, other alternatives include apps like Expensify and Budget Boss allow you to immediately log and categorize your transactions. Bringing that data to someone like us then gets things into the best fitting categories possible — and if we’re working with your CPA, then I know what deductions to look for and we’ll be proactive in how we approach your books.
Want to learn more about how you can prepare your records to lower your tax brackets? If you’re in the San Francisco Bay Area, I invite you to get in touch for a free initial consultation.
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