By Dr. James M. Dahle, WCI Founder
Understanding how the tax brackets work will aid your tax planning and make for more informed, reasonable discussions of tax policy.
Now that we're entering 2022, with inflation rising higher and higher (not to mention, hopefully, your investment portfolio), let's take a look at the new tax brackets and see how best you can plan for the new year.
For context, here were the tax brackets for 2021:
Here's how that will change for 2022, via the IRS and the Tax Foundation.
The standard deduction has also been raised for 2022. Here's what it was in 2021.
And here's what it'll be for 2022.
So, it's a slight increase for both the tax bracket limits and the standard deductions, but it's nothing out of the ordinary.
People Don't Understand How the Brackets Work
One of the most interesting phenomena I've noticed over the years is that most people don't actually understand how tax brackets work, and they routinely overestimate how much they pay in taxes. For example, I put up a few Twitter polls last year discussing tax brackets. Take a look:
Keep in mind, these are not opinion questions.
These questions actually have correct answers that can be easily calculated and, frankly, given how far apart the answers are from each other, pretty easily estimated. It's like asking "Is China closer to Vietnam, Switzerland, Cuba, or Tonga?" Yet only 27%-30% of people got the answers right. Sheer random chance would allow 25% of them to get it right. But what is more interesting is that 61%-73% of respondents OVERestimated the tax burden.
Why People Don't Get Tax Brackets
There are a few reasons why people can't answer those questions right. Well, not everyone. Rick Ferri was very proud to nail all three.
But most people couldn't estimate the right answer to the questions. I think I know why.
#1 People Don't Understand the Difference Between Marginal Tax Rates and Effective Tax Rates
Remember that your marginal tax rate, or tax bracket, is the rate at which your next dollar earned will be taxed. Your effective tax rate is the total tax paid divided by your total income. Your effective tax rate is always less than your marginal tax rate. Perhaps this is best illustrated by demonstrating how to come up with the right answer to the question.
If a married couple earns $100,000 in 2022 and takes no deductions besides the standard deduction, how much will they pay in federal income tax?
First, they subtract out the standard deduction of $25,900. That leaves $74,100. The first $20,550 is taxed at 10%, generating $2,055 in tax. That leaves $74,100 – $20,550 = $53,550. That $53,550 all falls within the 12% tax bracket and so is all taxed at 12%. $53,550 x 12% = $6,426. $2,055 + $6,426 = $8,481. $8,481/$100,000 = 8.5%. The numbers were slightly different in 2021 when I first tweeted out that example (8.6% instead of 8.5%), because of the new tax bracket limits. But you get my point.
There are two key points here. The first is that there is a 0% bracket. Some of your income is not taxed at all. That might be the standard deduction. It might be itemized deductions. There might be some above-the-line deductions. Whatever. But anything you get a deduction for isn't taxed at all. It's in the "0% bracket." Some critics on Twitter started listing all these other deductions that could be taken. However, all of those would have LOWERED the tax due. This is, in essence, the MAXIMUM tax paid on that income, not the minimum. So most people still overestimated the tax due, even though I used the maximum tax possible in this situation.
The second is simply that being in the 12% bracket does not mean you pay 12% in taxes. You only pay taxes on the money in that bracket. You fill the brackets as you go. Otherwise, you would have paid $12,000 in taxes instead of $8,481. So if you knew someone making $100,000 was in the 12% bracket, you should know that the answer to the question MUST be less than 12%. There is no reason whatsoever to guess a number higher than that.
#2 People Don't Understand the Difference Between Taxes Withheld and Taxes Paid
Most people are employees. They don't actually calculate out how much tax they owe and send it to the IRS each quarter like business owners do. It is just pulled out of their paycheck by their employer before they get it. The newer withholding tables are more accurate than the older ones, but most employees still have more withheld than they actually owe. That's why they get these huge tax refunds every spring. That is another phenomenon I find interesting—just how bizarrely happy people are to loan money interest-free to their government. But I think it contributes to the idea that people think they pay a lot more in taxes than they do.
#3 People Don't Know What Federal Income Tax Is
There are also a lot of people who don't know the difference between all of the taxes we pay. Don't get me wrong: there are a lot of taxes. There are state and local income taxes. There are payroll taxes like Social Security tax, Medicare tax, one of the two types of Patient Protection and Affordable Care Act (PPACA) taxes, and unemployment tax. There are sales taxes and property taxes and gas taxes and inheritance taxes and estate taxes. I guess it should be no surprise that people cannot tell them apart. Several of these are also withheld from their paychecks (the state and local income taxes and payroll taxes like Social Security taxes, Medicare taxes, and one of the two PPACA taxes). In fact, some of those payroll taxes (and the other PPACA tax) even show up on their federal income tax return, further confusing the situation.
Most people DO pay significantly more than 8.5% of a $100,000 income in taxes, but not in federal income taxes. The federal income tax is quite progressive (44% of people pay no federal income tax at all while others have marginal tax rates as high as 37%). However, there are other taxes that are not progressive. My state income tax in Utah is a flat tax, at least once you get past the deductions. Medicare tax is a flat tax—2.9% on all wage income, half from the employer and half from the employee. Social Security tax is also flat—12.4% on all wage income, half from the employer and half from the employee (but only up to an income of $142,800 in 2021 and an income of $147,000 in 2022). After that, it goes to 0% (at least for the employee), thus becoming a regressive tax at upper incomes.
At any rate, people may not realize that the federal tax brackets only apply to federal income tax.
#4 People Think Everything Taken Out of Their Paycheck Is Tax
Even worse, some people just assume everything taken out of their paycheck before they get it is a tax. Including their retirement account contributions, their share of any life or health insurance premiums, or even court-ordered child support. Sorry, those are good things to pay, but they're not taxes, much less federal income taxes.
I think it is important to understand how our taxes, especially the largest one for most of us—the federal income tax—work. Knowing how they work will help you to better manage your own finances and to actually have intelligent discussions with others about government and tax policies.
What do you think? Why do you suppose most people couldn't answer the questions above correctly? Why is the tax code so mysterious to US citizens? Comment below!
[This updated post was originally published in 2020.]
The post 2022 Tax Brackets — How They Actually Work appeared first on The White Coat Investor - Investing & Personal Finance for Doctors.
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