How Income Tax Rates Work

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If I was Aladdin, and had three magic wishes of my own, my wishes would be as follows:

1. World peace
2. Healthy children
3. And to teach every adult in the United States how income tax rates work

Yes, that’s a little sarcasm. But who says financial planning can’t be fun?

Pop Quiz

Don’t feel bad, if you get the following one question quiz wrong because you’re not alone. There are very smart people (I have seen a lawyer, a business owner, and a professor), answer this wrong.

Jim, who is single, makes $100,000 each year. This puts Jim in the 28% tax bracket. How much federal income tax does Jim pay each year?

• A: $28,000
• B: $21,709

My guess is that most people say $28,000. Even though that answer makes a lot of sense, it’s wrong. The answer is B, $21,709.  (Income Tax Calculator)

The 28%, represents the rate Jim pays on the last dollar he earns. This doesn’t mean he pays 28% on each dollar he earns, just the last dollar.

The first dollar Jim earns, is taxed at a different rate. The following brackets are the tax rates for a single person in 2010:

Tax Rate	Single
10%	$0 - 8,375
15%	$8,376 - 34,000
25%	$34,001 - 82,400
28%	$82,401 - 171,850
33%	$171,851 - 373,650
33%	over $373,650

Knowing the tax bracket, you can then breakdown what Jim is taxed on each dollar he earns:

Income Tax Rates Breakdown

Income Between	Tax Rate	Amount Taxed
($8,375 minus 0)	10%	$837.50
($34,000 minus 8,375)	15%	$3,843.75
($82,400 minus 34,000)	25%	$12,100
($100,000 minus 82,400)	28%	$4,928
Total		$21,709

This system is in place so there’s no perfect income for someone to attain. If it wasn’t, everyone would attempt to earn just under the highest bracket. For example, your goal would be to earn $82,400 and not a penny more.

Conclusion

Just a simple but very important lesson today. If this is all new to you, you can now consider yourself more knowledgeable than most when it comes to tax brackets.

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Photo by: Beverly & Pack

Tagged as: Income, tax