How to deduct business expenses on your income tax return - Tax-Rates.org Library How to deduct business expenses on your income tax return

By Jonathan Weber, Tax-Rates.org
Deducting business expenses is one of the single most powerful tools in any tax-preparation strategy, and is often one of the most misunderstood.

In this article, we will discuss who can qualify for business expense deductions, what expenses can be deducted, and how your deductions must be recorded and reported.

The information discussed in this article is relevant to entrepreneurs, self-employed people, business owners and shareholders, and employees who have paid out-of-pocket business expenses.

What Business Expenses Can Be Deducted?

While the exact deductions you can take depends on the tax structure and nature of your business, in most cases sole proprietors can deduct the following qualified expenses from their gross business income:
  • Cost Of Goods Sold – The cost of any goods or raw materials you purchase and resell is always 100% deductible. For example, a woman who sells paintings at a local craft show will be able to deduct the costs of paint and canvas for each piece sold.
  • Advertising - All advertising fees are fully deductible. Examples include classified ads in the local paper, radio or television ads, and most sponsorships
  • Business Supplies & Tools - The cost of any supplies and tools needed exclusively for business use are fully deductible. For an artist, any purchases of paintbrushes, easels, and other supplies can be deducted.
  • Vehicle Expenses - Certain vehicle expenses – including rental costs and mileage – can be deducted for qualifying business use of your vehicle. Commuting expenses cannot be deducted.
  • Contract Labor & Services - If you hire contractors or freelancers to work for your business, fees are fully deductible. You can also deduct fees paid to hire professionals such as lawyers and repairmen for business-related services.
  • Office Expense - You can deduct any costs associated with maintaining your business workplace or office. If you work from home, you can deduct the percentage of your home costs directly related to your business.
  • Travel & Entertainment - You can deduct travel-related business costs, and up to 50% of your qualifying business entertainment costs. All travel and entertainment costs deducted must be related solely to your business, and cannot include any recreational expenses.
  • Additional deductions including depreciation, depletion, taxes, and insurance premiums may also be deductible based on your particular situation.
Who can deduct business expenses?

Business expenses are normally associated with corporations – entities which are distinct and separate from the owner(s) and employees. In most cases, business expenses are reported on a corporate income tax return instead of on a personal income tax return.

However, there are a variety of situations in which you, the taxpayer, may wish to deduct business expenses on your own personal income tax return. If you are a self employed professional, own a home-based business, or are a shareholder in an S-Corporation or partnership, your business deductions can be listed directly on (or passed through to) your personal income tax return.

If you are an employee who has paid business expenses out-of-pocket, you can deduct some or all of your business expenses by itemizing them on Schedule A of your personal income tax return.
 
Business expense deductions for sole proprietors and self-employed taxpayers

If you are the sole proprietor of an unincorporated business or an LLC (which is an unincorporated business to the IRS), you can deduct all qualifying business expenses directly on your income tax return by filing Schedule C. In order to be qualified as a business, you must engage in related business activities with “continuity and regularity” with the intent to make a profit.

Common examples of individuals who can claim Schedule C business expenses are self-employed professionals (contractors, consultants, photographers, etc), individuals who run a home-based business (such as a childcare service, a regular booth at a local market, etc). Most business activities that are not associated with an incorporated entity are reported on Schedule C.

As the owner of a Schedule C business, you have the right to deduct all qualified business expenses from your gross business income – resulting in either a net gain, or a net loss, to your Adjusted Gross Income. You must list your deductions in the Business Expenses section of Schedule C (seen below), and retain receipts to prove your expenses in the event of an audit.



Business expense deductions for shareholders in an S-Corporation or Partnership

S-Corps and Partnerships are different from Schedule C businesses in that they can be owned by multiple shareholders. While these businesses are not subject to taxation like C-Corporations, business deductions in an S-Corp or a Partnership are reported on a business tax return and not on an individual shareholder’s tax return.
  • An S-Corporation must report all business expenses  on Form 1120S, “U.S. Income Tax Return for an S Corporation”
  • A partnership must report all business expenses on Form 1065, “U.S. Return of Partnership Income”
If the business has multiple shareholders, the deductions – like the income distributions – will effectively be equally distributed to all of the shareholders based on their investment in the company. If the business is owned by s sole shareholder, all of the deductions – and profit distributions – will flow through to that individual’s tax return as a distribution.

In addition to the normal deductible business expenses, S-Corps  and Partnerships also allow the easy deduction of wages, officer compensation, and employee benefits. See the excerpt the expenses section of Form 1065 (partnership income return) below.



Business expense deductions for employees with non-reimbursed business expenses

While fundamentally different from deducting expenses for a business in which you are an owner or shareholder, the IRS does provide a method for employees of a corporation to deduct business expenses they paid out-of-pocket. Generally, these expenses involve entertainment of clients (such as taking a client out to lunch to discuss business) or unreimbursed travel expenses (such as hotel or meal expenses).

If you itemize deductions on your personal income tax return, and your unreimbursed expenses amount to 2% or more of your AGI, you can itemize and deduct these expenses directly on your 1040. Keep in mind that general expense deduction rules, like the 50% entertainment deduction rule and mileage rates for business travel, also apply to employees claiming these expenses as an itemized deduction.

To claim unreimbursed business expenses, list the sum on Schedule A (your itemized deductions worksheet) under “Job Expenses and Certain Miscellaneous Deductions”. You must also also include Form 2106, “Employee Business Expenses”, where you must itemize your expenses and make sure they qualify for deduction.

Frequently Asked Questions – Income Tax - Tax-Rates.org Library Frequently Asked Questions – Income Tax

By Jonathan Weber, Tax-Rates.org

1. Withholding & Estimated Tax

Who pays income tax?

The Federal Income Tax applies to most types of wage, investment, and self-employment income earned by all citizens or residents of the United States. If your income is over a certain threshold based on your age and filing type, you are required by law to file an income tax return (even if you don’t pay any income tax).

Filing Status Age of filer(s) Gross income
single under 65 $9,500  
  65 or older $10,950  
married filing jointly*** under 65 (both spouses) $19,000  
  65 or older (one spouse) $20,150  
  65 or older (both spouses) $21,300  
married filing separately any age $3,700  
head of household under 65 $12,200  
  65 or older $13,650  
qualifying widow(er) with dependent child under 65 $15,300  
65 or older $16,450  

Even if you don’t legally have to file an income tax return, you may want to file a return anyway to get withheld income refunded or to claim refundable tax credits. All individuals with income over the threshold must legally file an income tax return, or risk paying penalties and interest.


How does income tax withholding work?

If you work a normal job and receive a regular paycheck, chances are your paychecks are subject to income tax withholding. Income tax withholding is the percentage of your income that is withheld by your employer from each paycheck and sent to the IRS to cover Federal Income Tax and payroll taxes.

All of the money witheld from your paycheck is credited against your tax account by the IRS. When you file your tax return on April 15th, the amount of income tax you owe will be compared to the total amount of money you have already paid through tax withholding over the course of the tax year.

If your tax withholding exceeds the amount of tax you owe, the IRS will send you the difference as an income tax refund. If you have not paid enough through withholding alone, you will have to pay the difference when you mail or e-file your tax return.

You can change the amount of each paycheck that is withheld by modifying your W4, which is on file with your employer’s Human Resources department. While paying to little through tax withholding could result in IRS fines, there is no advantage to pay too much in tax withholding – this only results in a large tax refund at the end of the year.


Do I have to pay quarterly estimated taxes?

If you are self employed or earn money through methods not subject to tax withholding (like investments or jobs that pay in cash), you may have to pay quarterly estimated tax payments to the IRS.

As a rule of thumb, if you have to pay over $1,000 to the IRS when you file your tax return you haven’t had enough tax withheld and must make quarterly tax payments. If you have a variable yearly income, you should have at least 100% of your last year’s tax bill – or 90% of this year’s expected tax bill – withheld or paid through quarterly tax payments.

Failing to make quarterly payments, if you are required to do so, can cost you in IRS penalties and interest – so make sure to make your payments on time. For more information on quarterly taxes, see How To Pay Estimated Taxes.

2. Filing Your Income Tax

What tax deductions and credits can I qualify for?

Tax deductions and tax credits are two of the most common ways of reducing your income tax liability. Tax deductions are expenses you can deduct from your total income before calculating your taxable income, while tax credits are credits that can be deducted directly from the amount of tax you owe.

Deductions: All Americans can claim the Standard Deduction on their tax return, which varies based on your filing status (but is approximately $6,000). Everyone is also entitled to one Personal Exemption for each dependent, including themselves, a spouse, and children.

You also have to option to itemize deductions instead of claiming the Standard Deduction – this allows you to deduct expenses including mortgage interest, property tax, and certain medical expenses. Generally, you should only itemize if your total itemized deductions add up to more then your Standard Deduction.

Credits: Popular tax credits for lower-income taxpayers include the Earned Income Tax Credit (EITC) and the Child and Dependent Care Credit. Students can claim the American Opportunity Tax Credit and/or the Lifetime Learning Credit, which can help offset tuition costs. Other popular credits include the Retirement Contribution Credit for qualified retirement savings accounts, and the First Time Homebuyer Credit for taxpayers purchasing their first home.


How can I e-file my tax return online?

E-filing your tax return is the quickest and easiest way to submit your forms to the IRS. The easiest ways to e-file are by using income tax software like TurboTax or by using a paid tax preparer. Lower and middle-income taxpayers can often get basic tax software at no charge through the IRS’s FreeFile Alliance program.

Premium tax software costs between $35 and $100, and professional tax preparers can cost more then $150. For more information about the different methods of e-filing your federal and state income tax returns, see How To E-File Your Tax Return.


How can I check my tax refund status?

If you e-filed your tax return, you can expect to get your refund direct deposited into your bank account in 10-21 days. Refunds for mailed returns can take up to two months to process. Once your tax return has been received, you can check the status of your refund through the IRS’s automated systems.

72 hours after e-filing, or 4 weeks after mailing your return, you can check your refund status by calling the IRS Refund Hotline at 1-800–829–1954 or by logging onto the Where’s My Refund tool on IRS.gov. For more details, see Requesting Your Income Tax Refund.


What are the penalties for failing to file or pay?

The IRS has a long laundry list of penalties and interest that will be immediately attached to your tax bill if you fail to file an income tax return or pay your complete tax bill. Here’s a list of some of the major penalties that apply:

  • You pay a failure-to-file penalty if you don’t file your tax return, and a failure-to-pay penalty if you fail to pay by the due date
  • Failure-to-file Penalty: 5% of unpaid taxes per month, up to 25%
  • Failure-to-pay Penalty: 0.5% of unpaid taxes per month, up to 25%
  • After 60 days, the minimum penalty is the smaller of $135 or 100% of unpaid tax

The failure-to-file penalty is very steep, and the IRS recommends that you file a tax return (or request an extension) even if you cannot pay your full tax debt by the due date. If you can prove that you did not file or pay due to reasonable cause, the IRS may agree to waive your interest and penalties.


What is an IRS Tax Audit?

An IRS Audit is a double-check of your tax return by IRS agents, which may result in changes to your return and the amount of tax you owe. IRS audits are often triggered by automated algorithms filtering for returns with abnormal combinations of deductions or tax credits, or the discovery of unreported income (like a 1099 that was not listed on your tax return).

The IRS will notify you of an audit by telephone or through the mail. Audits may be completely through the mail, but more often will involve you (or your representative) meeting with an IRS agent at the IRS Headquarters, a field office, or in your home. The IRS will propose changes to your tax return, and you have the right to agree, or to disagree and present supporting evidence through an appeal.

Generally, you can be audited on any of your last three years’ worth of tax returns. The statute of limitations for major errors can be extended to up to six years of tax returns.

3. Miscellaneous

How are state income taxes calculated?

Of the 41 states that collect a general income tax, most collect a progressive income tax based on marginal tax brackets just like the Federal Income Tax. Several states collect a flat (regressive) income tax instead of using tax brackets.

To simplify calculation, states often allow you re-use many aspects of your federal tax return on your state return – including your AGI, qualifications for popular tax credits, and itemized deductions. However, states often have unique standard deductions, personal exemptions, and tax credits. You will need to fill out your state tax return separately from your federal tax return, and ensure that you’ve adjusted your deductions and credits to reflect your state’s individual tax laws.

For more information, you can compare state income taxes and find out more about your state in our section Income Tax By State.


How does the U.S. income tax compare to other countries?

Compared to most other first-world countries, the United States has a relatively low personal income tax burden. Many European countries have maximum tax brackets of 50% or more, not including social security or other payroll taxes. The United States’ top tax bracket of 35% is among the lowest for developed countries.

In business income taxes, however, the United States lags behind a good percentage of the developed world. The chart below shows how the the United States ranks among 30 of the top first-world countries in personal and business income taxes.

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TurboTax 2012 Income Tax Software Review - Tax-Rates.org Library TurboTax 2012 Income Tax Software Review

By Jonathan Weber, Tax-Rates.org

Tax law is exceedingly complicated, and as many who have attempted to wade through piles of tax paperwork on their own can attest, often exceedingly frustrating to deal with manually. For many Americans who choose to handle their tax returns themselves, completing and double-checking tax forms can turn into a nightmare.

Luckily, dozens of tax software suites make it possible and even easy to manage and submit your tax returns online. Tax-Rates.org has reviewed some of the best income tax software available in order to help you choose the tools that are right for you.

TurboTax Federal & State Tax Software

TurboTax is a powerful tax suite that can handle both federal and state tax returns. The program is designed to ensure that you receive your maximum tax refund with simple multiple-choice questions that can help you claim over 350 updated deductions.

Pros: One of the best features about TurboTax is the wide variety of time-saving tools and features available. TurboTax can import tax data from previous years (even if you didn’t use TurboTax), and can instantly load W-2 forms and other tax information directly from your employer. This can save an incredible amount of typing and time.

Cons: The popular free version of TurboTax supports both federal and state returns, but only supports free e-filing for your federal return. You can print and send your state return in for free, but you have to purchase a state e-filing package ($39.95) if you want to e-file your state income tax return as well.

TurboTax has four editions, ranging from free software for basic returns to a full-service tax prep suite for self-employed business owners. You can compare the features, and price, using the table below.

Price & Features Comparison of TurboTax 2012 Editions
TurboTax Free Edition
This edition is FREE if you file form 1040EZ
$0.00
Buy
TurboTax Deluxe Edition
Suitable for most filers earning W-2 wages and 1099s. Supports 300+ deductions and credits
$49.95
Buy
TurboTax Premier Edition
Specifically for taxpayers with investment income or rental properties
$74.95
Buy
TurboTax Home & Business Edition
Files both advanced personal and business returns for self-employed taxpayers
$99.95
Buy

We found all editions of TurboTax to be intuitive and easy to use – the software offers turn-by-turn instructions and helpful suggestions to help you navigate through the various refunds and tax credits available, and can import and double-check all of the tax forms seamlessly in the background.

The program has been designed around prominently maximizing your refund on both your federal and state tax returns, as can be seen in the example screenshot below:


TurboTax Refund Example

Overall: TurboTax is arguably one of the most well-rounded tax suites available, and definitely goes the extra mile when it comes to saving time and maximizing your tax refund.

If you have a simple tax return (with only wage income and 1099s), TurboTax Free is unbeatable for e-filing your federal return, both in ease and price.

For only $49, the deluxe edition is also an excellent buy for most taxpayers that offers the same or better guidance for a much more affordable price then a professional tax preparer.

Learn more about TurboTax Income Tax Filing Software
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How to get a copy of your income tax return - Tax-Rates.org Library How to get a copy of your income tax return

By Jonathan Weber, Tax-Rates.org

If you need a copy of your federal income tax return for any reason, you can request one for free from the Internal Revenue Service. The IRS Order A Transcript service can provide you with two types of basic tax transcripts:

  1. Tax Return Transcript – Your Tax Return Transcript includes can copies of your 1040 and most of the add-on schedules filed with that year’s tax return. You should request a tax return transcript if you need a full copy of your tax documentation, which may be necessary if you lose your records or need to provide a copy of your tax return to a third party like a government agency or your mortgage company.
  2. Tax Account Receipt – The IRS can also provide you with a Tax Account Receipt, which is a simple document including basic information about your tax account like your adjusted gross income and taxable income. This transcript can be useful for applications that require your tax status, like the Department of Education’s FAFSA application.

You can request a transcript or a receipt for the current tax year, or for any of the last three tax years. There is no fee for either a transcript or a receipt. This article will show you, step by step, how to order a Tax Account Receipt. Ordering a Tax Return Transcript follows most of the same steps.


CONTENTS



REQUEST DOCUMENTS ONLINE

  1. Visit the official IRS Web site at www.irs.gov
  2. In the Tools section of the homepage, click “Order a Return or Account Transcript”
  3. Chose item #3, “Order a Transcript”
  4. Enter your Social Security Number, date of birth, street address, and zip code. If you are requesting a jointly filed return, you will need to enter the information of the primary tax filer here
  5. Click “Continue”
  6. In the Type of Transcript field, select “Account Transcript” or “Tax Return Transcript” and in the Tax Year field, select “2012” or the year you would like to request
  7. If the information you submitted is valid, you can expect to receive a paper copy of your requested transcript within 5-10 days

REQUEST DOCUMENTS OVER THE TELEPHONE

  1. Call the IRS document hotline at 1-800-908-9946
  2. Follow the automated prompts and enter the SSN of the primary filer, your address as on file with the IRS, and any additional information requested
  3. Select “Option 4” if you want to request an IRS Tax Account Transcript and then enter “2012” (or the tax return year you need)
  4. If the information you submitted is valid, you can expect to receive a paper copy of your requested transcript within 5-10 days

REQUEST DOCUMENTS USING IRS FORM 4506-T

  1. If you need to request an account transcript, use IRS Form 4506-T. Otherwise, use IRS Form 4506T-EZ
  2. Download 4506T-EZ at http://www.irs.gov/pub/irs-pdf/f4506tez.pdf
  3. Complete lines 1-4, following the instructions on page 2 of the form, with your personal information.
  4. Line 5 allows you to have your IRS Tax Account Transcript or Tax Return Transcript mailed directly to a third party by the IRS (this option is not available online and over the phone)
  5. On Line 6 of Form 4506-T, enter the tax forms you need a copy of (ex. “1040”)
  6. Choose either Box A (Tax Return Transcript) or Box B (Account Transcript)
  7. On Line 9 of Form 4506-T, enter the year for which you are requesting your transcript
  8. Sign and date the form and enter your telephone number. Only one signature is required for a joint return.
  9. Mail or fax the completed IRS Form 4506-T to the appropriate location provided on page 2 of Form 4506-.
  10. If the information you submitted is valid, you can expect to receive a paper copy of your requested transcript within 30 days. If the information included on the form is invalid, the IRS will notify you

EXAMPLE TAX ACCOUNT TRANSCRIPT

Tax return transcripts are commonly used for proof of income and proof of tax status. Below is an example of a certified IRS tax return receipt.

Tax Return Transcript

List of states with no income tax or sales tax - Tax-Rates.org Library List of states with no income tax or sales tax

By Jonathan Weber, Tax-Rates.org

There are a total of nine states with no or limited income taxes, and five states with no statewide sales tax. Of these, there are only two states that have both no state income tax and no sales tax:

  1. Alaska – Alaska has no statewide income tax, and no statewide sales tax – but local governments are allowed to collect a local sales tax of up to 7.5%. Alaska has consistently ranked as the state with the lowest tax burden in the nation.
  2. New Hampshire – New Hampshire has no statewide income tax (although it does collect income tax on dividend and interest income), and no statewide or local sales taxes. Like Alaska, New Hampshire consistently ranks among the top five lowest taxing states in the nation.

Although both Alaska and New Hampshire have notably low combined tax burdens, both of them – especially New Hampshire – have higher median property taxes than most other states.

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List of states with no income tax - Tax-Rates.org Library List of states with no income tax

By Jonathan Weber, Tax-Rates.org

A total of seven states have no state income tax, and two states tax only interest and dividend income. Forty-one states and the District of Columbia collect a general state income tax. Here’s a list of the seven states with no personal income tax as of 2012:

  1. Alaska
  2. Florida
  3. Nevada
  4. South Dakota
  5. Texas
  6. Washington
  7. Wyoming

Two states do not tax normal income, and only collect an income tax on income from dividends and interest income:

  1. New Hampshire
  2. Tennessee

If you live in any of these states, you do not have fo file a state income tax return and are only responsible for paying federal income taxes on your income.

While residents of these income-tax-free states do have a significantly lower income tax burden then those in high-tax states like California or Oregon, some of these states make up for lost tax revenue by raising other taxes like sales taxes, property taxes, and excise taxes.

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How to calculate your federal income tax refund - Tax-Rates.org Library How to calculate your federal income tax refund

By Jonathan Weber, Tax-Rates.org

For many Americans, tax season can bring about a windfall in the form of a Federal income tax refund check. You will receive a refund check if and only if you paid more then your total tax debt over the course of the year through tax witholding. This article will teach you how to calculate your expected tax refund, and how to ensure that your refund check reaches you successfully.

Calculating Your Total Tax and Total Payments

The size of your federal tax refund depends on two things – your total tax owed and your total tax witholding.

    1. Calculate your total tax (including all deductions, adjustments, and other taxes) on line 61 of your 1040 form. This is the amount you owe.
    2. Calculate your total tax payments on line 72. Tax payments include all income tax withheld by your employer on line 62 (check your W-2 or 1099 forms), estimated tax payments on line 63, and any tax credits you may qualify for. The total on line 72 is your total tax paid.

Calculating Your Income Tax Refund

Your tax refund is simply the difference between the amount you paid and the amount you owe. If you paid too much, you have several options for your refund.

    1. If your total payments on line 72 are greater then your total tax owed on line 62, write the difference in the refund box on line 73.
    2. In lines 74 and 75, you can choose to have your refund paid to you (as a check or through direct deposit) or applied directly to next year’s taxes (useful if you have to pay estimated taxes).

Getting Your Tax Refund Quickly

Now that you’ve calculated your refund, there are several steps you can take to ensure you receive it in a timely manner.

    1. eFile Your Tax Return – The IRS has to process millions of tax returns every year – if you eFile, they will be able to process your return (and your refund) much more quickly. eFiled returns will receive refunds in as little as 1-3 weeks, while paper returns can take up to 6 weeks to be processed.
    2. Request Direct Deposit – Requesting that your refund be direct deposited instead of requesting a check can also speed up your refund process by up to a week. Direct deposit is fast and secure, and you can choose up to 3 separate accounts (including checking, savings, and retirement accounts) to receive your refund. You can request direct deposit on line 74 of your 1040.

If you eFile your tax return, you can expect to receive your refund within 10-21 days.

Checking Your Refund Status

Starting 72 hours after you eFile (or 4 weeks after you mail a paper return), you can check on your refund’s status through the IRS’ “Where’s My Refund?” system.  Collect the following information before making your refund inquiry:

  • Your Social Security Number
  • Your current filing status
  • The dollar amount of the refund you requested (from line 73 of your 1040)

With this information in hand, you can check the status of your refund either online or over the phone by calling the IRS Refund Hotline at  1-800–829–1954 or by logging onto the IRS Where’s My Refund website.

Solving Problems With Your Refund

If you received an incorrect refund amount, your refund was never issued , or your refund check was lost or stolen, contact the IRS immediately at 1-800-829-1040 and they will be able to reissue your refund as necessary.

Getting Your State Income Tax Refund

If your state collects income tax, you must apply for a refund on your state income tax return, and you will receive a separate refund payment. Most states also provide an easy-to-use refund status portal – see your state’s income tax information page for more details.

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Introduction to marginal income tax brackets - Tax-Rates.org Library Introduction to marginal income tax brackets

By Jonathan Weber, Tax-Rates.org

One of the most common misunderstandings encountered when dealing with income taxes is the concept of marginal tax brackets, and how they are used to calculate your income tax.

Marginal tax brackets are a progressive tax bracket system, which means that the effective tax rate increases as taxable income increases. Marginal tax brackets are used to calculate your federal income tax, as well as state income taxes in most states that collect an income tax. In addition to personal income taxes, marginal tax brackets are also used when calculating federal and state corporate income taxes.

In the media and everyday conversation, you may often hear references to somebody’s “tax bracket” – for example, “Most full-time employees are in the 25% tax bracket”. This language can help create the false impression that individuals “in the 25% tax bracket” actually pay a full 25% of their income in taxes. This is not true, as we will soon see. Due to the nature of marginal income tax brackets, the actual amount of tax dollars paid by an individual in the top half of the 25% tax bracket is closer to 18% of their total income [1].

A marginal income tax means that the actual tax collected on each dollar you earn depends on the total amount you have earned between the first day of the tax year and the moment you earned that dollar.

For example, let’s consider a simplified version of the 2012 federal income tax brackets: [2].

Tax BracketMarginal Tax Rate
$0-$10,00010%
$10,000-$35,00015%
$35,000-$80,00025%
$80,000-$170,00028%
$170,000-$370,00033%
$370,000+35%

Let’s say you earn a salary of $60,000 a year, or $5,000 per month. Starting on January 1st (the beginning of the most commonly used tax year), you have earned a total of $0. Like everyone else, you start in the 10% tax bracket, which covers earnings from $0-$10,000. Therefore, you will owe 10 cents per dollar in income tax for the first dollar you earn – and for every dollar you earn up to the $10,000 cap.

On January 31st, you receive your $5,000 monthly paycheck. You have earned a total of $5,000 since January 1st, and all of the $5,000 you earned falls below the $10,000 cap for the 10% tax bracket. Therefore, you owe a total of $5,000 x 10% = $500 in federal income tax for your January earnings.

In February, you earn another $5,000. This is also included entirely in the $0-$10,000 tax bracket, so you also owe a total of 10%, or $500, of your February earnings in income tax. So far, you’ve earned a total of $10,000 since January 1st and have paid 10%, or $1,000, of your total earnings in federal income tax.

Now, because you’ve earned a total of $10,000 so far through February, you’ve reached the cap of the first tax bracket. The next dollar you make, the $10,001th dollar, will be included in the second  tax bracket – $10,000-$35,000. In this tax bracket you will pay 15%, or 15 cents per dollar, in federal income tax. When you receive your $5,000 paycheck at the end of March, you will owe 15%, or $750, in taxes.

Now, at the end of March, you have earned a total of $15,000 in wages and paid a total of $1,750 in income tax. This includes 10% of your January earnings, 10% of your February earnings, and 15% of your March earnings. You’re currently earning in the 15% tax bracket, but if we average the effective tax rate you paid on each dollar we find that you have only paid a total of 11.67% of your total income in taxes [3]. This is the nature of a progressive tax bracket system.

Here’s how the complete yearly tax breakdown looks for our example, for all $60,000 in wages earned from January 1st to December 31st. Wages are broken down into their applicable tax brackets, including total dollars earned and total tax paid in each bracket.

Dollars EarnedTax BracketTax RateTax Paid
$10,000$0-$10,00010%$1,000
$25,000$10,000-$35,00015%$3,750
$25,000$35,000-$80,00025%$6,250
$60,000 18.33%$11,000

In words, here’s how your income is broken down into tax brackets:

  • You paid 10% of your first $10,000, earned in January and February
  • You paid 15% of yout next $25,000, earned from March through July
  • You paid 25% on your last $25,000, earned from August through December

In our example, you find yourself in the upper half of the 25% tax bracket at the end of the year but you’ve only paid 18.33% of your income in taxes – a full 6.67% lower then your current tax bracket if taken at face value. We like to call this the marginal tax bracket effect.

One interesting observation of the marginal tax bracket effect is that its effects get less noticable as your total income goes up. While our previous example paid 6.67% less then the 25% tax bracket’s face value, an individual at the top of the 28% tax bracket earning $170,000 per year will pay about 24.24% of their income in taxes – only 3.76% below face value:

Dollars EarnedTax BracketTax RateTax Paid
$10,000$0-$10,00010%$1,000
$25,000$10,000-$35,00015%$3,750
$45,000$35,000-$80,00025%$11,250
$90,000$80,000-$170,00028%$25,200
$170,000 24.24%$41,200

Why does the marginal tax bracket effect seem to diminish as you earn more? It’s a simple matter of rounding. The higher tax brackets are, by design, much wider then the lower brackets. For example, compare the $10,000 wide 10% bracket with the $90,000 wide 28% bracket. With more and more of your income falling into your highest tax bracket as your income goes up, the tax savings you get at the lower brackets become statistically less significant.

As you have seen in the previous examples, marginal tax brackets mean that the total percentage of income you pay in taxes is not the same as the face value of your highest tax bracket. While marginal brackets are somewhat more complicated to calculate then a simpler flat tax, they do come with benefits. Specifically, the marginal income tax system is designed to lower the overall tax burden on lower and middle-income taxpayers, while ensuring that taxpayers of all incomes pay the same marginal percentage in each respective bracket regardless of which bracket they fall in at the end of the year.

As the core of the American income tax system, understanding how marginal brackets work is a key step in understanding and taking control of your finances. Armed with this knowledge, you should be better prepared to make more informed tax and financial decisions in the future.

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