 Income tax 2023-2024, marginal and average tax rates. Get ready and some coffee so we can lessen the sting from the tax man's smack with income tax preparation 2023-2024. In a prior presentation, we discussed different types of taxes, including a flat tax and a progressive tax, noting that the federal income tax is a type of progressive tax. However, we also noted that most taxes in practice can be thought of as kind of in between a flat and progressive tax. Or in other words, if we think of a spectrum, the flat tax on the left-hand side, the progressive tax on the right-hand side, we can imagine a strictly flat tax where, as income goes up, we just apply the same rate. However, once things become more progressive, then you can basically always get more progressive from that point in time until you tax like 100% of income, which means you're back to basically a flat tax at that point. So if we're in the realm of a progressive tax type of system, you're going to hear language such as, do we want to make the system flatter? You can talk in terms of the flat side of things, flattening out the taxes, or less flat, meaning you're going to be moving away from the left towards the progressive. Or you can use the progressive terminology and say, I'm going to be speaking from this point of view. If I'm in the middle, I'm going to make things more progressive or I'm going to make things less progressive. Those are the directions that you can go if you're already in the middle with some kind of progressive tax. Now, as we go to the right, making things more progressive or less flat, that usually comes along with more complexity in the tax code, such as more layers of different types of taxation. Usually when we move to the left, that's going to obviously have less complexity as we flatten the code. So as different administrations come in and try to put in policies, some will talk about flattening the tax code, which means they're trying to simplify the tax code typically. And others will talk about making the tax code more progressive, which means they're going to try to add more layers or increase the tax rates possibly at the upper layers would be the general idea. First, a word from our sponsor. Yeah, actually, we're sponsoring ourselves on this one because apparently the merchandisers, they don't want to be seen with us, but but that's okay. Whatever, because our merchandise is is better than their stupid stuff. Anyways, like our crunchy numbers is my cardio product line. Now, I'm not saying that subscribing to this channel, crunchy numbers with us will make you thin fit and healthy or anything. However, it does seem like it works for her. Just saying. So, you know, subscribe, hit the bell thing and buy some merchandise so you can make the world a better place by sharing your accounting instruction exercise routine. If you would like a commercial free experience, consider subscribing to our website at accountinginstruction.com or accountinginstruction.thinkific.com Now, if we have four more years of what we currently have, we might not have any of that, but instead we'll just get like a deduction for, I don't know, chocolate chip ice cream or something like that. And then maybe another inflation reduction act making fuel and energy more expensive. What was explained? What is inflation again? I forgot. Anyways, so the general idea here is that once we have the progressive tax system in place, then we have these this issue of what's the actual rate of tax that we are paying. Because now we can think of the average tax and we can think of the highest tax or what we would call a marginal tax rate, which is kind of an economic term. This becomes really important because you want to be able to communicate clearly how much tax you're actually paying and you also want to be able to plan going out into the future. So how does this materialize? So we see that we have a progressive tax system. We have different tax rates as as the income goes up and we have to have different tax rates depending on filing status because single filers will of course have less income than head of households. In other words, if you put it, I mean, sorry, then Mary, if you put two people together, then you would expect that their potential for income is doubled. However, I mean, again, that becomes more complex because it depends on family structure and kids and all that kind of thing. But that's the general idea, right? You've got a single person, you've got double the people, they might make twice the income. And then we've got the head of household and the married filing jointly. We'll talk about them later. Let's remove that for now and just think about the single filer to make it easy at this point to think about the concept of an average tax rate and a marginal tax rate, noting that the 10% is at this range. So from 0 to 11,000. Now note when I'm talking 0 to 11,000, we're talking about taxable income. This also becomes confusing because this is the bottom line of the income statement. So we're not talking about the top line, what you put in what your W2 wages were, for example, you still have deductions from their standard deductions itemized deductions. We'll talk about that later. But when we're thinking about applying the actual tax, we're talking about the taxable income credits also also complicate the whole situation as well. But we're saying, okay, we have the taxable income 0 to 11,000, that can be taxed at the 10%. If we move up to the 12%, that means that we're not taxing everything at 12%, back down to 0 at 12%. We have everything up above this level being taxed at 12%. So now we have two tiers. Now the benefit of that is that that makes kind of sense, right? Because now you're going to say, okay, we're going to just tax at this rate on the lower level. And then if you make more money, we'll tax more. That means there's a disincentive to make more money over a certain level. But it kind of makes sense that if your income goes up, then if they tax all the income at 12%, if you made one more dollar, 11,001 dollars, and then all your income jumped up to 12% instead of 10%, you would have a huge disincentive not to make that extra dollar. But if it's only that one dollar that's going to be taxed at 12%, then I'm not as fearful of working more to make that extra dollar that jumped to the next tax bracket is not as big a deal. However, it is more complicated to calculate on our end because now, of course, we have this tier and this tier. So the tax software will do that for us when we do the tax preparation. However, your goal, our goal when we're doing our own taxes or someone else's taxes is to feel that we're comfortable that we did it correctly. So it becomes more and more explaining what is happening in the software, deconstructing what's happening in the software so we can tell the client and or ourselves what exactly is going on here, right? Instead of just being blindly following the software in which case we're probably going to have more anxiety because we don't know if the software is actually doing it correctly or not, right? So then if we go to the 44,725 up to the 95,375, then we're jumping up to the next tax bracket. Okay, so that's the general concept of what is going up. We're going to keep on jumping up to these higher tax brackets. The software is going to basically take care of that. So the actual tax preparation should be fairly easy. We're going to have to be able to explain this concept to the clients, however, in terms of how the tax is calculated. So the client's going to want to know, well, how much tax am I actually paying? And it's like, okay, then we can try to give an idea of what this table is saying to give a concept of how much tax is actually being paid. And we can capture that number with, of course, the average, right? We can try to say, okay, I'll give you the average tax. And the average, it's kind of like if you've ever seen Rocky Balboa's old movie, but he's a boxer and his trainer would say, he says, I see three of them out there. And the trainer says, hit the one in the middle, right? That's what the average is, right? You've got the bell curve. You hit the one in the middle, which is great for explaining the tax rate. Now, again, it's not perfect because it's still really quite complicated to try to explain to someone how much tax they're paying on a percentage basis because it's not on their gross income. It's on the net income. And then the credits also really kind of muddy up the picture. But when you're attempting to do that, the average tax rate is the way to typically go. That's the one that's going to try to capture how much tax that you actually paid. So like I say, the Rocky advice, the trainer's advice to Rocky the boxer is usually good because once Rocky said, okay, I'm going to hit the one in the middle, he went out there and won. However, there are times when just hitting the one in the middle isn't the way to go. So we'll talk about that in a second here. The average tax rate is pretty easy. We can take the taxable income, which isn't the gross income. It's the taxable income and divide it by, I'm sorry, we'll take the total tax and divide it by the taxable income. So if the total tax that was paid was 20,000 and the taxable income was 100,000, then we take the average tax rate, which is 20%. Now the average tax rate is by definition going to be in between all of the tax bracket rates that we actually use to calculate the tax because it's somewhere in the middle, right? The average is somewhere in the middle. So the highest tax rate would be higher than that amount. So when would that be important? Well, that's going to be important whenever there's a change in the taxes. And this is where the complexity comes into the code. Because again, a lot of people say, oh, the tax code being complex is not a problem because me as a tax preparer, all I do is plug it into the software and the software takes care of it. It's not a problem. And I've heard that argument like at CPA firms and whatnot, and it's just, it still kind of boggles my mind that because obviously where the complexity becomes a problem is trying to project into the future, which all businesses, individuals, households need to do. So even if the software can magically calculate it really easily, you still have the issue of trying to project what's going to happen in future years where the software doesn't even have all the information. The changes to the tax law, the changes to the tax rates, we don't know if that chocolate chip ice cream is going to be deductible in the future. We don't know if the inflation reduction act is going to make us pay $1,000 for a tank of gas or something. We don't know what's going on here. So it's kind of hard to predict into the future. Now, when you are predicting into the future, you don't want to pick the one in the middle. You want to use the marginal tax rate, the tax rate of the last dollar of income. And so we use marginal. That's like an economic tax, an economic term. So in economics, the general idea would be you want to make the decision from the point you are at to the next decision that is being made. In other words, if you're looking back to all the money that you spent in the past, you're going to run into a sunk cost effect. The question is, what's the step to take from here going forward? And when you're looking at the tax rates, if I'm at like a 24% tax bracket, my average tax might have been down here at 20%. But if I'm making more money, if I'm going to make more money or less money, then I can't budget based on how much tax... If I'm going to make another $100,000 next year or whatever, then I can't... If I try to say that I'm going to have an average of 20%, then I'm going to underestimate how much tax I'm going to owe because I'm already at the highest tax bracket. The next thing that's going to happen from this point in time is going to be at a tax rate of 24% and then go up to the next tax bracket of the 32%. The next dollar is not going to be taxed at the average rate of the 20%. So when we're actually thinking about activities, what we are going to do from this point in time, the marginal tax rate is the one you typically want to at least start with and then move up the tax brackets from there depending on what's actually going to happen in the future. So it's kind of like with Rocky, it doesn't work all the time. Hit the one in the middle, great advice doesn't work all the time because if your opponent takes a quick dodge to the right, then if you hit the one in the middle, you're still... Because your vision's blurred, that's not the one anymore because now he's on the right. So now you got to hit the one on the right, which is the marginal tax rate. And that's where we are with this one. And if Rocky had that advice, he would not have gotten hit in the face so many times, I think. I feel like if he was a little bit more sophisticated in that advice. So that's the general idea. So the average tax rate, great tool to try to explain this whole progressive tax system in one number to help people understand where their taxes are. It can be misleading, however, because then when they earn more money, they're going to use the average tax rate. It would be the natural thing to do. I'll hit the one in the middle, try to use the average tax rate to calculate how much I'm going to be paying in the future. But no, that will be wrong. You will drastically under withhold if you do that. When you make decisions, you have to make them on the margin, the 24% rate. So if you're going to make more money, you got to start there. If you're going to make less money, you still got to start there because you're going to drop down bracket by bracket. So if you make a few thousand dollars less or whatever, you're going to have to say you were taxed at 24. So your taxes are going to go down more dramatically than they otherwise would on the average tax rate. So that's the general idea. We'll make this more concrete with some examples in tax software shortly.