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Income Taxes

Marginal Tax Rate vs Effective Tax Rate

 

Taxes are an integral part of the workings of money, they are not just a mandatory payment but a crucial mechanism for funding the services and investments necessary for a functioning and prosperous society. They contribute to the economy, provide essential public goods and services, and underpin the social contract between citizens and their government. There are several types of taxes imposed on money as it is used, which broadly include income taxes, consumption taxes, and property taxes.

"In this world nothing can be said to be certain, except death and taxes."
-- Benjamin Franklin

Income taxes are taxes imposed on individuals or entities with respect to their income or profits. These taxes are typically calculated as a percentage of taxable income, which is the total income minus any allowable deductions. The tax rates can vary depending on the taxpayer's income level and filing status.

The main areas of income taxes are Individual, corporate, payroll, and capital gains.

Taxable Income is the amount of income that is subject to taxation. It's calculated by subtracting deductions from gross income. Gross income includes all income from various sources like wages, salaries, tips, investment income, and business profits.

Tax Brackets, a progressive tax system, which means that different portions of income are taxed at different rates. The seven income ranges are called tax brackets. As income increases, it falls into higher tax brackets with higher tax rates. For the 2025 tax year, the federal income tax brackets for a single filer are:

10% on income from $0 to $11,925
12% on income from $11,926 to $48,475
22% on income from $48,476 to $103,350
24% on income from $103,351 to $197,300
32% on income from $197,301 to $250,525
35% on income from $250,526 to $626,350
37% on income over $626,350

The tax brackets vary for other filing statuses such as married filing jointly, married filing separately, and head of household.

Marginal Tax Rate is the tax rate applied to the next dollar of income earned. It's important to understand that when your income moves into a higher tax bracket, only the income within that new bracket is taxed at the higher rate, not your entire income.

Effective Tax Rate is the actual percentage of your total income that you pay in taxes. It's calculated by dividing your total tax liability by your taxable income. The effective tax rate is usually lower than your marginal tax rate due to the progressive nature of the tax system.

Deductions are expenses that can be subtracted from your gross income to reduce your taxable income. There are two main types of deductions:

Standard Deduction is a fixed amount that taxpayers can choose to deduct based on their filing status. For the 2025 tax year, the standard deduction for a single filer is $15,000.

Itemized Deductions are specific expenses that taxpayers can deduct if the total exceeds the standard deduction. These can include things like state and local taxes (limited to $10,000), mortgage interest, charitable contributions, and medical expenses (above a certain threshold).

Tax Credits directly reduce the amount of tax you owe, unlike deductions which reduce taxable income. Tax credits can be non-refundable (meaning they can reduce your tax liability to $0 but you won't get any of the credit back as a refund) or refundable (meaning you can get some or all of the credit back as a refund even if it reduces your tax liability to below $0). Examples of tax credits include the child tax credit, earned income tax credit, and credits for education expenses.

Filing Status is determined by your marital status and family situation on the last day of the tax year. The five main filing statuses are: Single, Married Filing Jointly, Married Filing Separately, Head of Household, and Qualifying Surviving Spouse. Your filing status affects your standard deduction, tax brackets, and the credits and deductions you can claim.

Tax Withholding applies to most employed individuals, income tax is withheld from each paycheck throughout the year. The amount withheld is based on the information provided on Form W-4, which employees complete and give to their employers.

Estimated Taxes apply to individuals who are self-employed, have significant income from sources other than wages (like investments), or don't have enough taxes withheld from their pay may need to pay estimated taxes throughout the year to avoid penalties. These payments are made to the IRS on a quarterly basis.

Tax Day in the United States is the deadline for filing federal income tax returns and paying any taxes owed is generally April 15th of each year. However, if this date falls on a weekend or holiday, the deadline is usually moved to the next business day. Taxpayers can also request an extension to file, which typically gives them an additional six months, but this does not extend the deadline to pay any taxes owed.

Calculating Income Tax

1. Determine your gross income: Add up all your income from various sources.
2. Calculate your adjusted gross income (AGI): Subtract certain above-the-line deductions (like contributions to 401(k), traditional IRAs, student loan interest payments, etc.) from your gross ncome.
3. Determine your taxable income: Subtract either the standard deduction or your total itemized deductions from your AGI.
4. Calculate your tax liability: Use the appropriate tax brackets for your filing status to figure out how much tax you owe based on your taxable income. You'll calculate the tax for each portion of your income that falls within a different tax bracket and then add these amounts together.
5. Apply tax credits: Reduce your tax liability by any tax credits you are eligible for.
6. Determine if you owe additional tax or are due a refund: Compare your total tax liability to the amount of taxes you have already paid through withholding or estimated tax payments.

It's important to keep accurate records of your income and expenses throughout the year to make tax preparation easier. The IRS website (www.irs.gov) provides a wealth of information, forms, and publications to help taxpayers understand their obligations. Tax software and professional tax preparers can also assist with navigating the complexities of income tax.

Nine out of 10 taxpayers take the standard deduction, according to the IRS. Others are able to itemize deductions because they have enough additional items such as mortgage interest, property taxes, charitable donations and medical expenses. You take these deductions off of gross income to get to your taxable income. Your tax liability is based on that.

A person with $75,000 of taxable income will have a portion of the income taxed at 22%, but not all portions are taxed at that rate. They typically would have an effective tax rate of 15%. Someone with $150,000 of taxable income will have a top rate of 24%, but the “effective” rate is lower than that, typically 19%.

Main Income Tax Types

Individual Income Tax: This is a tax on the income individuals or households earn. It's applied to various forms of income, including wages, salaries, self-employment earnings, investments, and retirement income. Federal income tax in the U.S. is progressive, meaning higher earners pay a larger percentage of their income in taxes. Many states and some local governments also levy individual income taxes.

Corporate Income Tax: This tax is levied on the profits of corporations. Profits are calculated as revenue minus the costs of doing business. In the U.S., both federal and state governments impose corporate income taxes.

Payroll Tax: Payroll taxes are levied on the wages and salaries of employees. In the U.S., the primary payroll taxes fund Social Security and Medicare. These taxes are typically split between employers and employees.

Capital Gains Tax: This tax applies to profits from the sale of assets like stocks, bonds, real estate, and other investments. The tax rate can vary depending on how long the asset was held (long-term vs. short-term capital gains) and the taxpayer's income bracket.

 

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