How tax brackets actually work

Vox

18 Jan 201902:47

Summary

TLDRThe script clarifies a common misconception about tax brackets, emphasizing the importance of understanding marginal tax rates. It explains that instead of a flat rate, taxes are paid in 'pockets' with increasing rates as income grows. The 'special pocket' for deductions is highlighted, showing how only the incremental income from a raise is taxed at higher rates, not the entire income. The script aims to demystify tax policy discussions and dispel myths about tax rates affecting the entire income.

Takeaways

💡 Tax brackets for 2019 can be misunderstood when calculating federal taxes.
📊 A common mistake is thinking that your entire income is taxed at the rate of your highest bracket.
💰 Example: An $84,000 income might seem to be taxed entirely at 22%, but this is incorrect.
🏦 The government allows a standard deduction ($12,000 for singles), reducing taxable income.
📉 After deductions, the remaining income is taxed in portions or 'pockets' at different rates.
🔟 The first pocket is taxed at 10% for the first $9,700.
📈 The next portion of income is taxed at 12%, and then 22% as income increases.
📥 Marginal tax rates mean only the money in the highest bracket gets taxed at that rate.
🤑 Raises are taxed at the next available marginal rate pocket, not entirely at the highest rate.
🗣️ Politicians' proposals to change tax rates often affect only the highest income brackets, not all income.

Q & A

What is the common mistake people make when looking at tax brackets?
-The common mistake is assuming that the entire income is taxed at the rate of the bracket it falls into, rather than understanding that tax rates are applied progressively to different portions of the income.
What is the special pocket mentioned in the script, and how does it work?
-The special pocket refers to the standard deduction, which is an amount of income that is not taxed. Single individuals can automatically deduct $12,000, and couples can deduct more, with additional deductions possible for certain expenses like medical expenses or charitable donations.
How does the concept of 'pockets' relate to tax brackets?
-The concept of 'pockets' is a metaphor for the progressive nature of tax brackets. Each pocket represents a different portion of income that is taxed at a specific rate, starting from the lowest bracket and moving up as the income increases.
What are marginal tax rates, and how do they apply to an individual's income?
-Marginal tax rates are the tax rates applied to each additional dollar of income as it falls into different tax brackets. They apply to the portions of income that have filled up the lower brackets and are then taxed at the next highest rate for the income in the next bracket.
How does a raise affect the taxation of an individual's income?
-A raise increases the income in the first available pocket with empty space. Once that pocket is filled, the additional income is taxed at the next higher marginal tax rate, meaning only the raise, and not the entire income, is partially taxed at the new rate.
What does it mean when politicians talk about raising the top tax rate?
-When politicians discuss raising the top tax rate, they are referring to increasing the tax rate for the highest income bracket. This does not necessarily affect the tax rates of the lower brackets or the majority of an individual's income.
Why is it important to understand the concept of marginal tax rates?
-Understanding marginal tax rates is important because it clarifies how taxation works on different portions of income and helps to dispel misconceptions about how much of one's income the government might 'take away'.
How can deductions affect an individual's taxable income?
-Deductions reduce an individual's taxable income by allowing them to subtract certain expenses from their total income before tax rates are applied, potentially lowering the overall tax liability.
What is the purpose of the script in the video?
-The purpose of the script is to educate viewers on the correct understanding of tax brackets and marginal tax rates, and to clarify common misconceptions about how taxes are applied to income.
How does the script suggest responding to politicians' claims about tax rates?
-The script suggests that viewers should educate themselves on the concept of marginal tax rates and be prepared to challenge politicians' claims by understanding how tax brackets actually work.

Outlines

00:00

💼 Understanding Tax Brackets and Deductions

This paragraph explains the common misconception about tax brackets and how they actually work. The speaker clarifies that tax rates should be thought of as 'pockets' instead of brackets. They illustrate this with an example of an $84,000 income, explaining how deductions can increase the amount of income not taxed, and how the remaining income is taxed at different rates in different 'pockets'. The concept of marginal tax rates is introduced, showing how only the new income from a raise is taxed at higher rates, not the entire income.

Mindmap

Keywords

💡Tax Brackets

Tax brackets are the ranges of income that are subject to different income tax rates. In the video, the speaker clarifies a common misconception about how they work, emphasizing that each portion of income is taxed at the rate corresponding to its bracket, not the entire income at the highest rate.

💡Mistake

The term 'mistake' in the script refers to the misunderstanding that people make when they believe their entire income is taxed at the rate of the highest bracket it touches. The video aims to correct this mistake by explaining the concept of marginal tax rates.

💡Income

Income is the money received, typically from employment or investments, on which taxes are levied. The script uses a specific income example of $84,000 to illustrate how tax brackets apply to different portions of one's income.

💡Federal Government

The federal government is the central governing body of a nation, responsible for setting and collecting taxes. In the context of the video, it is the entity to which the taxpayer owes a portion of their income as taxes.

💡Deductions

Deductions are expenses that can be subtracted from an individual's taxable income, reducing the amount of tax owed. The script mentions medical expenses and charitable donations as examples of deductible expenses.

💡Pockets

In the script, 'pockets' is a metaphor for tax brackets, indicating the different portions of income that are taxed at different rates. The term helps to simplify the concept of marginal tax rates for the viewer.

💡Marginal Tax Rates

Marginal tax rates refer to the tax rate applied to each additional dollar of income as it falls into a higher tax bracket. The video uses this term to explain how only the income that exceeds the lower brackets is taxed at the higher rates.

💡Raise

A 'raise' is an increase in pay. The script uses the example of getting a raise to demonstrate how only the additional income is subject to higher tax rates, not the entire income.

💡Politicians

Politicians are individuals who hold or seek political office. The video mentions politicians to highlight how their statements about tax rates can be misleading without understanding the concept of marginal tax rates.

💡Top Tax Rate

The top tax rate is the highest tax rate applied to the highest income brackets. The video clarifies that changes to the top tax rate only affect the portion of income that falls into the highest brackets, not the entire income.

💡Uninformed Debates

Uninformed debates refer to discussions about a topic where participants lack accurate knowledge. The script points out that misunderstandings about tax brackets lead to uninformed debates about tax policy.

Highlights

These are tax brackets for 2019.

Many of us make a common mistake when looking at this.

Let's say my income is $84,000.

You might think that puts me in the third bracket.

I would owe the federal government 22% of my income.

This is wrong, and it's causing us to have uninformed debates about tax policy.

Instead of thinking of tax rates as brackets, we should think of them as pockets.

The money we put in this pocket is not taxed. The government automatically lets single people put $12,000 in this special pocket — and more for couples.

If you spend a lot of money on things like medical expenses or charitable donations, you can sometimes put in more. These are called 'deductions.'

With the $70,000 that’s left over we can start filling up the pockets.

The first pocket has room for $9,700, so I only pay 10% on this money.

Then I pay 12% on the money in the next pocket.

Then 22% on the money in this pocket. These are called marginal tax rates.

So if I get a raise, that new money goes into the first pocket with empty space. When space runs out, we put it in the next pocket.

The raise, and only the raise, would be partially taxed at 22% and partially at 24%.

When politicians say they want to raise the top tax rate, it doesn't necessarily mean these pockets — and your money — are affected.

They're talking about the tax rates on the pockets way over there, which are only used once people have filled in these smaller ones.

Marginal tax rates are a pretty simple concept, once you get the hang of it.

Next time a politician says the government wants to 'take away 70% of your income,' just send them this video.