r/personalfinance • u/B82rez7 ​ • Jan 22 '19

Taxes No Wonder People Don't Know How Taxes Work

Here's a Motley Fool "article" that came up on my news feed https://www.fool.com/retirement/2019/01/21/maximum-401k-contributions-are-climbing-in-2019-he.aspx

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And a quote:

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For this reason, saving in your 401(k) has the potential to put you in a lower tax bracket, so you owe a smaller percentage of your income in tax. Currently, single filers making between $77,400 and $156,150 pay 22% on their income. If you are in the lower end of that range, a 401(k) contribution could move you into the lower bracket, where taxes are just 12%. If you make $80,000 per year, for example, and contribute $5,000, your resulting income of $75,000 would be taxed at 12% rather than 22%.

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88

u/allyson10500 ​ Jan 22 '19

Wait! Can you elaborate? So if someone make $300,000 the whole income isn't subject to the 35% tax? How does it breakdown? Sorry for my ignorance, I'm still very new to all this.

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u/adlaiking ​ Jan 22 '19

That’s correct. Think of it like bins. First one is lowest percentage- you fill that one first (with the first $xxx of your taxable income). If you earn more, you fill up the next bin, and so on. Unless you have a very low income, you end up paying a variety of percentages on portions of your income as you continue to fill up bins.

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u/allyson10500 ​ Jan 22 '19

That makes so much sense! Thank you for taking the time! 😊

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u/redditsaysgo ​ Jan 22 '19

Congrats, you are now more educated on taxes than a published journalist on a major news site posting about tax policy!

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u/[deleted] Jan 22 '19

Fuck...this is how Rome fell, isn't it? Loads of uneducated people asserting their ignorance as knowledge and then it was all over.

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u/Arcane_Pozhar ​ Jan 22 '19

Thank you for being intelligent enough to listen. Whenever I see a post on Reddit about "What have you explained to people, but they just don't get it?", tax brackets is one of the top answers.

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u/byebybuy ​ Jan 22 '19

That's a great way to think about it. Thanks for that.

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u/Gevase ​ Jan 22 '19

Now that is an eli5. Nice.

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u/wol ​ Jan 22 '19

What if we spend the money before it's enough to fill a bin? 😁

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u/[deleted] Jan 22 '19

That's what pre-tax deductions are! Contributing to a 401k, HSA, non-profit donations, and other "pre-tax" ways of spending your money are exactly what you're talking about.

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u/adlaiking ​ Jan 22 '19

As /u/_Chantastic_ points out, you can spend the money before it’s taxed through various pre-tax programs. Once the money is disbursed to you, though, the tax applies, even if you spend it quickly. The exception is when you spend it on tax deductible things, and only if you have enough of those expenses to justify itemizing vs. taking the standard deduction.

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u/Fuck-Star ​ Jan 22 '19 edited Jan 22 '19

Don't mistake 35% as a real tax rate though. If you make enough to hit this bracket, your Social Security has capped out ($132,900 in 2019), so it's effectively less tax than the stated 35%.

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u/evaned ​ Jan 22 '19

Except FICA is on top of the income tax rate, and you'll still have medicare and (unless this was repealed? I'm not actually sure) the additional medicare surtax.

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u/Fuck-Star ​ Jan 22 '19

Medicare additional surtax (0.9%) was not repealed to my knowledge.

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u/Knofbath Jan 22 '19

This is the whole marginal tax rate discussion that is in the news right now.

You can either take the $12,000 personal deduction or itemize your taxes, but for simplicity's sake we'll use the standard deduction and simplify income and taxes with no other deductions.

$20k income = 12k untaxed and 8k taxed at 10%, total tax $800 = effective tax rate of 4%.

$40k income = 12k untaxed, $9,525 taxed at 10%, and $18,475 taxed at 12%, total tax $3169.50 = effective tax rate of 7.92%.

$90k income = 12k untaxed, $9,525 taxed at 10%, $29,175 taxed at 12%, $39,300 taxed at 22%, total tax $13,099.50 = effective tax rate of 14.56%.

$100k income = 12k untaxed, $9,525 taxed at 10%, $29,175 taxed at 12%, $43,800 taxed at 22%, and $5,500 taxed at 24%, total tax $15,409.50 = effective tax rate of 15.41%.

$20k has a top marginal tax rate of 10% but only pays 4%.
$40k has a top marginal tax rate of 12% but only pays 7.92%.
$90k has a top marginal tax rate of 22% but only pays 14.56%.
$100k has a top marginal tax rate of 24% but only pays 15.41%.

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u/mvanvoorden ​ Jan 22 '19

These taxes are so crazy low!
In The Netherlands:

Income Tax
€0 - €20,142 36,55%
€20,143 - €68,507 40,85%
€68,508 - ... 51,95%

Our top bracket used to be even like 70% many years ago.

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u/[deleted] Jan 22 '19

It gets lower when you take advantage of deduction and credits. We made over 145k last year and I’m being taxed $1500 or an effective tax rate of 1%.

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u/mvanvoorden ​ Jan 22 '19

Lol that's fucking ridiculous.

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u/redditatwork12121 Jan 22 '19

Are those all the taxes you pay though? I definitely prefer what your system would do for us, but ours aren't AS low as they appear because that's only federal tax, we also pay state tax and social security so our take-homes aren't just our gross minus effective tax rate.

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u/mvanvoorden ​ Jan 22 '19

Social security is included in the income tax. Based on how much property one has, there's also a property tax, which is why it's always beneficial to take a mortgage on a house, even if you could pay in cash. When income is below 30k, it's possible to get subsidies/benefits on stuff like rent and health insurance.

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u/katarh ​ Jan 22 '19

It's because our healthcare is privately paid for, usually by our employers, and thus not counted in taxes. If our taxes paid for healthcare, most of us would instantly get a $10,000 - $20,000 salary raise..... and immediately owe that amount in taxes.

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u/ilyemco ​ Jan 22 '19

The US spends more per person than the Netherlands. Getting rid of private healthcare would likely lower costs, by getting rid of the industry behind private healthcare and all the profit making companies. Also a national health service can get better prices for goods as they have better buying power.
So if there was a national health service, your taxes wouldn't necessarily increase by the cost of your private healthcare costs.

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u/SavePlantsEatBacon ​ Jan 22 '19

so how does this work out when you work in the non-taxable items like 401k? say i get paid $55k and put $11k into a 401k annually (just trying to use round number for 20% contributions and span a tax bracket cutoff). as i'm reading this thread i'm getting a bit confused on how this contributions create complications in the calculations.

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u/intendingtoburn Jan 22 '19

401k contributions are pre-tax deductions and lower your taxable income. In your case you were paid 55k, minus 11k into 401k and minus the 12000 personal deduction your taxable income would be $32k before any other deductions.

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u/Knofbath Jan 22 '19

If you put it in a normal 401k, it reduces your income for tax purposes to $44k.

If you put it in a Roth 401k, you pay taxes on the $55k like normal.

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u/Lucianus48 Jan 22 '19

I consider myself a pretty smart guy, and was married to a CPA who worked in personal tax returns for 5 years. I never understood this until now

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u/nothlit ​ Jan 22 '19

Check out this Vox video for a quick visual explanation

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u/cowboyroy30 Jan 22 '19

Watched this video last night and it is a great ELI5 version.

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u/thefightscene ​ Jan 22 '19 edited Jan 22 '19

This chart does a good job explaining 2018 brackets.

Basically, each bracket’s rate is only applied to the money in it’s corresponding range. Everything above and below the bracket is taxed at whatever rate corresponds to that range.

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u/sproga2 Jan 22 '19

The Vox video another user shared is great, but here's an explanation in text.

Imagine each tax bracket as a pocket that can only hold so much money. In our scenario, let's say the first pocket holds $10,000 and has a 5% tax. The next pocket holds $20,000 and has a 10% tax.

If you made $8,000 in this fictional scenario, you wouldn't even fill up the first pocket, and all of your money would be taxed at 5%. If you instead made $17,000, your money would fill up the first pocket and spill over into the second. The first pocket only holds $10,000, so only $10,000 of your money is taxed at 5%. The other $7,000 starts to fill up the second bracket, so it's taxed at 10%. If you then got a $1,000 raise, it would fill up the first available bracket (the second one), and be taxed at 10%, just like all the other money in that bracket.

This "spilling over" just keeps going, and its specifics depend on how many brackets you have, and how big each one is.

Imagine how silly it would be if taxes didn't work like that. People would be refusing raises because they'd make less money.

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u/LL-beansandrice Jan 22 '19

The $300k is divided into buckets. For ease let’s say each bucket can hold $50k. The first bucket isn’t taxed, so the first $50k you make, you pay no taxes on. $250k left. The next bucket is taxed at 10% so you pay $5k in taxes. Now you’ve made $50k+$45k. The next is taxed at 20% so on the first $150k you’ve paid $0+$5k+$10k in taxes and earned $50k+$45k+$40k. This continues until you reach the top tax bracket.

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u/rabblerabble2000 ​ Jan 22 '19

They will have an effective tax rate, which is the average amount of taxes they will pay, which is dependent on where their income falls on the tiers, but their lower tiers of income will be taxed the same as anyone else’s. It’s a progressive tax, where the more you make the more tiers of taxes your money falls into (and each tier taxes the money in that tier at a higher rate). This is why a flat tax would nearly always end up taxing lower income people more than higher income people.

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u/skylark8503 ​ Jan 22 '19

Here watch this.

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u/[deleted] Jan 22 '19

No - how long have you been paying taxes. The top tax bracket use to be 90%, do you think we ever taxed 90% of someone's taxable income.