Benjamin Franklin once said, “Nothing is certain except death and taxes.” But is that really true?
As the tax code has grown more complex, fewer people understand how the U.S. tax system works. In fact, according to a recent survey, fewer than half of all taxpayers know which tax bracket they fall into.
To better understand our federal tax system, let’s explore a metaphorical story. First, we’ll go out for a meal with friends, then we’ll discuss how taxes are applied to our income.
A Tale of Ten Lunches
Imagine ten friends who decide to go out for dinner after work. They plan to split the bill.
Each friend has a $10 meal, making the total bill $100. However, instead of everyone paying $10, the bill is divided in a way similar to our progressive tax system:
- Friends 1, 2, 3, and 4 effectively pay $0
- Friend 5 pays $1
- Friend 6 pays $3
- Friend 7 pays $7
- Friend 8 pays $12
- Friend 9 pays $18
- Friend 10 pays $59
In our current tax system, approximately 40% of wage earners pay no federal income tax (Friends 1, 2, 3, and 4) due to various tax credits and a substantial standard deduction.
The tax code has seven brackets, ranging from 10% to 37% (10%, 12%, 22%, 24%, 32%, 35%, and 37%), and most of the revenue is generated from the top 10% (Friend 10) of taxpayers, who fall into the highest brackets.
What is a Progressive Tax System?
The U.S. has a progressive tax system for each individual or household. Think of each of the seven tax brackets as a bucket. Income fills up the first bucket, and any remaining spills over into the next, and so on.
The money in each bucket is taxed at the rate for that bracket. The total tax owed is the sum of the tax for all buckets.
Tax Planning That Just Make Sense
When planning for taxes, Ben Franklin’s “certainty” isn’t exactly true. When helping clients with tax planning, we use strategies to move income between tax brackets based on a long-term tax outlook.
Our goal isn’t to minimize this year’s tax bill but to reduce lifetime taxes. This approach sometimes involves paying more taxes today to save later.
If you’d like help assessing your tax situation and finding a strategy that fits your needs, feel free to let us know!
