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The Graduated Income Tax

How are income taxes calculated?

Why do people who make more pay more?

Many people do not know how federal income taxes are calculated. And some people do not know that the U.S. has a "graduated income tax". When you realize that you may pay more in federal and state income taxes over your lifetime than you will pay for anything else, except, possibly your house, you might wonder how these income taxes are calculated. Moreover, it is useful to know how the tax rate structure works. When doing tax planning to reduce taxes, sometimes income or deductions can be shifted into or out of the current year and into or out of the next year(s). Such shifts, although not changing the total amount of income or deductions, may change the total income taxes paid by reducing the tax rate applied to certain amounts of income. And knowing what your tax bracket is likely to be will help in planning investment and business transactions.

Tax Bracket

Although many people have heard the phrase, "tax bracket", they may not have a clear idea what it means. The graduated income tax system is designed so that the higher your income the more income tax you pay. As your income rises, a greater percentage of that income is taxed. The phrase, "tax bracket", refers to that portion of your income that is subject to the highest tax rate that is applied to your income. For instance, your taxable income may be subject to the lowest federal income tax rate, which is 15%. But, then, let us say, you get a year-end bonus. Some portion of that bonus may be taxed at the next highest rate, which is 28%. This happens because your regular income plus your bonus add up to more than the maximum amount of income subject to the 15% tax rate. You have now moved into the 28% "tax bracket". But only the portion of your total income that exceeds the certain maximum amount, or top of the 15% taxable income bracket, is subject to tax at 28%. Not all of your income is taxed at 28%, just a portion.

Calculation of Federal Income Tax - Example

I have provided a very simplified example of a federal income tax calculation to illustrate how greater income is taxed at a higher tax rate. The example is very simple because it starts with an assumed amount of total income, called in tax law, "Adjusted Gross Income". Most of the work to prepare an income tax return involves determining the amounts of income and deductions included in this "Adjusted Gross Income". It includes wages, interest and dividends, net income from businesses and rentals, gains on sales of stock, etc. Preparing an income tax return also involves identifying and computing "Itemized Deductions". My example assumes that the taxpayer does not itemize his or her deductions, but takes the "Standard Deduction." My illustration shows the easy part, just the income tax calculation - in fact, just the "regular" tax calculation. There may be other taxes such as the Alternative Minimum Tax and the Self-Employment Tax, and there may be tax credits. And of course, there would be the taxes withheld from wages or paid as "Estimated Taxes" which would be applied to the total tax liability to reduce the amount owing, or possibly result in a "tax refund." But I want to keep the example simple in order to show how income taxes are calculated and to show the effect of our graduated income tax system.

The Tax Rate Schedules

Even if you prepare your income tax returns yourself, you may never have looked at the "tax rate schedules" in the instructions that accompany the U. S. Individual Income Tax Return, Form 1040. Unless your taxable income exceeds $100,000, you used the "tax tables" to "find" your tax after you did all the work to compute your taxable income. The tax tables tend to obscure the rate structure. You may not be aware that the tax rate increases as your income increases. On the other hand, it is easy to see the rate structure by looking at the tax rate schedules. I have provided the federal income tax rate schedules for the most common filing statuses: single and "married, filing jointly". Upon inspection of the tax rate schedules, you can see that the portion of your taxable income that exceeds $25,750 if you are single, or $43,050 if you are filing a joint return, is taxed at 28% -- that is, until your taxable income reaches the 31% or higher brackets.

Copyright © 1999 Ira M. Freed

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