One of the core principles of the U.S. tax system is that it is progressive. This means that you will pay higher taxes as you earn more income, which is based on so-called “tax brackets.”
But the system hasn’t always achieved the goal of fairness. Some people pay large amounts of taxes even though they might not be rich. What’s more, many wealthy people have been able to pay trifling amounts. A famous example of this is Berkshire Hathaway Inc.’s (NYSE:BRK.A, NYSE:BRK.B) Warren Buffett, who has famously admitted that his tax rate is lower than his secretary’s.
To help avoid some of these problems, the IRS actually has two tax systems. One is the traditional approach, which affects most people. The other is the alternative minimum tax (AMT), which essentially disallows certain deductions and credits to try to ensure wealthy people pay higher taxes.
As should be no surprise, the rules can get extremely complicated, and it’s common for middle-class families to be affected by the AMT!
Regardless of all this, there are still some important concepts to understand about how taxes are structured and how they impact tax returns. Again, it’s about tax brackets, which are based on your income and filing status.
Here’s what the tax brackets look like if you are single:
|$0 to $9,275||10%|
|$9,276 to $37,650||$927.50 plus 15% of the amount over $9,275|
|$37,650 to $91,150||$5,183.75 plus 25% of the amount over $37,650|
|$91,150 to $190,150||$18,558.75 plus 28% of the amount over $91,150|
|$190,150 to $413,350||$46,278.75 plus 33% of the amount over $190,150|
|$413,350 to $415,050||$119,934.75 plus 35% of the amount over $413,350|
|$415,050 or more||$120,529.75 plus 39.6% of the amount over $415,050|
For example, suppose you earned $75,000 last year. Based on the chart above, you would take $5,183.75 and add $9,337.50 (this would be 25% of $75,000 minus $37,650), for a total of $14,521.25 in taxes. This means you will be in the 25% tax bracket (also known as your marginal tax rate).
However, you do not have to pay this for all your income. Part was taxable at 10% and some was at 15%. In other words, your average tax rate is somewhere around 19.4% ($9,337.5 divided by $75,000).
Keep in mind these tax brackets are for ordinary income, such as wages, commissions, tips, bonuses and so on. Yet there are different rates if you have long-term capital gains (this is if you hold an asset — like a stock, mutual fund, bond or real estate — for more than one year).
Here’s how they work, using the example of tax brackets for those who are married:
|Taxable Income||Tax Rate On Ordinary Income||Tax Rate On Long-Term Capital Gains|
|$0 to $18,550||10%||0%|
|$18,550 to $75,300||$1,855.00 plus 15% of the amount over $18,550||0%|
|$75,300 to $151,900||$10,367.50 plus 25% of the amount over $75,300||15%|
|$151,900 to $231,450||$29,517.50 plus 28% of the amount over $151,900||15%|
|$231,450 to $413,350||$51,791.50 plus 33% of the amount over $231,450||15%|
|$413,350 to $466,950||$111,818.50 plus 35% of the amount over $413,350||15%|
|$466,950 or more||$130,578.50 plus 39.6% of the amount over $466,950||20%|
If your income is $75,300 or lower, you will pay nothing for your long-term capital gains. In fact, the rate is only 20% if your income is at a hefty $466,950 or higher.
Awesome deal, right? And this is one of the reasons people like Warren Buffet pay such low taxes — they generate much of their income from long-term capital gains.