 Income tax 2023-2024, marginal and average tax rates example problem. Get ready and some coffee because we're looking to get the tax man off our back with income tax preparation 2023-2024. 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 that's okay whatever because our merchandise is better than their stupid stuff anyways. Like our trust me, I'm an accountant product line. Yeah, it's paramount that you let people know that you're an accountant because apparently we're among the only ones equipped with the number crunching skills to answer society's current deep complex and nuanced questions. If you would like a commercial free experience, consider subscribing to our website at accountinginstruction.com or accountinginstruction.thinkific.com Here we are in our example form 1040 practice problem using LISERT tax software. You don't need tax software to follow along but if you have access to tax software it could be a great tool to run scenarios with. You can also get access to the actual forms and instructions at the IRS website. irs.gov, irs.gov. Our typical starting point will be that we have our taxpayer, Adam Taxman. Adam Taxman is of course trying to avoid a dang tax man or tax woman and we have the social security number. We've got the address. We're in Beverly Hills 90210. I just used that because of the old show that no one knows about anymore at this point in time. We're not focused in on California taxes. We're focusing in on the federal income taxes. Next we have the filing status. Noting that in the future we'll go into each of these line items in more detail but we'll just point it out now because it will have an impact on our current discussion which is the average tax rate versus the marginal tax rate, a crucial concept to understand just in general. So we have the single filer. We've got no dependence at this point in time and then we have the first section of our formula income line which is of course broken out into all these different kinds of different income lines. We'll talk more about that later. But right now we're just going to imagine the simplest income of W2 income, the $60,000 that rolls down to the $60,000 here so that means that we have the total income of the $60,000. We have the standard deduction which we'll talk about later at the $13,850 and that gets us to the $46,150. So when we're talking about the actual tax calculation, note we're not typically talking about them being applied to the gross income but rather to what you can think about as net income or the taxable income, kind of like the bottom line of the income statement where we have this weird income statement which is the tax formula equation. Then we're going to be thinking about the rate that will be applied which of course won't be a rate but instead be something like these tables. So we've talked about these tables before which will differ based on filing status. This is a summary table. We can look at more detail about these tables by looking at each of the brackets. With the more detailed information, the reason this is useful is because then when I go up to a new bracket, for example, it'll give us a kind of a quick calculation of how the tables are working so that we can see the tax that will be calculated. Meaning here, for example, it's telling me this is the $1,100 from the 10% bracket plus 12% of everything and the new bracket up over $11,000 up to the ceiling of $44,725. And then if I go to the next bracket to 22%, we can see now it gives me this $5,147. The $5,147 would generally be the thought process would be, well, that's going to be the 10% of the 0 up to 11, 12% of the $11,000 up to $44,725. That's where they're getting this $5,147. So it makes it a little bit easier to think about how the tax is going to be calculated in the current tier but obviously to have this added line item from this line item where you have all of the filing statuses up top, you have to have a different table for each filing status. So this is the single versus the married versus married filing separately and head of household. So we'll talk more about the statuses later. I just want to point that out for now. Now many tax softwares actually have a calculation in a tax summary format. Let's go to the second page here first and let's see the tax calculation. Here's the tax that's being calculated. We can look at a worksheet here and we see basically the tables being applied, the 10%, the 12% and the 22% for the single filer. The single filer, the 10, 12, the 22, and they're within this tier. So that's going to be because they made 46 of taxable income. So they're within here highest rate of the 22%. So if we were to calculate that, you could see we're going from zero to 11. So the 11,000 times 0.1 is the 1,100 and then you're going to go from 44,725 minus the 11,001. So that's 33,724, which is taxed, they said 33,725, which is taxed at the 0.12, which is the 4047 and then the difference between here over that peak of 44,725 up to the 95,375. So the difference of these two, so we'd say then that's going to be the 95,375 minus the 44,7, actually no way to say the total taxable income from 6,175 minus the 44,726 gives us the 1,449 about and then I'm going to multiply that times the highest tax bracket 0.22 and that gives us our 319 about and if we add those up, 11,00 plus 4,017 plus 319 we get the 5,466. So you can see this could help you to kind of try to explain this to a client on what the actual taxes are being calculated are, although it's often useful to do some kind of average type of calculation to do that. So we could go and close this out and a lot of times a lot of some, a lot of tax softwares have a tax summary which is basically going to be a formula type basis. We'll mirror this formula in Excel as well so we can kind of break down each of these line items but there you have your wages again up top the 60,000 was earned, we have the deductions we're taking the higher of the standard versus the itemized and then we have our taxable income 46,150 that gives us our tax before credits the 5,466. So then if we look at our actual tax and I'm not really looking at the penalties I'm looking at the total tax okay well if I have the 5,466 divided by the taxable income 46,150 that's going to give us if we move the decimal two places over an effective tax or average tax of 11.8% so again notice what's happening here I'm taking the tax comparing it to the taxable income not the gross income if we were to compare it to the gross income before any deductions you'd say okay then you had the 5,466 divided by the gross income 60,000 what was actually on your W2 you're going to get a lower rate because you have the deductions in there and everybody gets basically a standard deduction so then of course the highest so that's the rate that you might use this effective rate to try to explain to people based on the bottom line after the deductions that you had then you have like an average or effective tax rate of the 11.8 and they might say okay great I think I'm going to make 50,000 more dollars next year so I'm just going to assume that I'm going to pay taxes next year of 50,000 times times 0.118 and it's like well no because first of all there's brackets involved and so you might end up with different brackets but you're starting out at 22% so the next dollar you make next year will not be taxed at 11.8% that's the average that's the one in the middle that's just to explain what is happening you're going to be taxed at the marginal rate the rate of your next decision your next decision is made at the margin at this point in time taking the next step forward like going up a step of stairs you're working on the next step and the next step is at 22% so if you make another 50,000 you're going to be taxed at the 22% or let's say another that's the general idea so if I increased the tax over here we can say okay what if I went to wages of 100,000 and go back on over so now the ordinary tax bracket is the 22% and the effective tax rate they're calling it the ordinary income tax bracket because you can also break out ordinary income versus the different types of income for capital gains for example so in essence this is going to be your ordinary income marginal tax rate your highest tax rate your effective tax rate they're using different terms but this is going to be basically your average tax rate we will throw in more complexity into this scenario when we have other things that are taxed at different rates so when we get into dividends they could be taxed at a different rate other than the ordinary income capital gains could be taxed at a different rate other than ordinary income and that can throw a wrench into the system to to 200,000 we'll say 200,000 and then we're going to say okay so now the ordinary income tax bracket the marginal rate is 32% at the peak at that point and the effective or average tax rate is at the 20.6% and that makes sense because if you look at our table here we're at the 32% we're at 200,000 so that we're in between here for a single filer so now if you put in a spouse notice what happens to these tables you would think they would all have to double because it's possible that you have two people that can make the double amount of income now this has been something that's changed over time because it used to be that if you think in terms of a single family a single income family home then that's not often the case where things just double with two people because one person might be taking care of the kids and stuff like that so but in theory you have two people now together and if we treat them as kind of separate entities and whatnot that have the potential to make the same amount of money then you would think you'd have to double all of these and you kind of want to do that in order to not disincentivize marriage and this is where it gets kind of complex on the tax code in terms of well if you change these brackets so that getting married is a disincentive that's going to have implant people are going to act on that you know so that's kind of so if so you can see here that 11 this 11 goes to the 22 and then the 44 here goes to the to the 89 and so on and so forth so typically for the normal brackets they kind of do the maximal thing making it the most benefit to get married even though it's not likely that the income is going to double if a family happens due to the fact that most people both spouses are probably not working full time you know in that situation so it's actually kind of incentivizing marriage at least on the higher income side of things we'll see that on the lower income side of things when you look at credits the reverse sometimes seems to be the case the credits actually work to disincentivize marriage so it's kind of an interesting dynamic on the higher income when you just look at the brackets it seems pretty driven towards getting married being better in terms of brackets which seems to kind of make more sense and then on the lower income side when you look at the credits it seems like disincentive for marriage which is kind of interesting but we'll look at that later so let's add a spouse then okay so now we've got now we've got Adam Taxman trying to avoid the dang taxman and Jane Taxman trying to avoid the dang taxman and they're married so now they're married on the filing status we'll talk more about that later but we're going to keep the income the same that it was before we looked at that at $200,000 and so now you can see the standard deduction doubled right which is because it was at single we'll talk more about this later but the $13,850 times 2 gets us to the $27,700 so they maximized what you would think that the standard deduction would be doubling it so now you've got those are like expenses gets to the taxable income $172,300 and then if I go to page number 2 we've got the actual tax calculation so we had double the expenses and the tax brackets were basically moved up you know kind of doubling the brackets as well so now you're saying from zero to $22,000 instead of $11,000 is that the 10% for $22,200 and then from the $22,000 up to the $89,450 then that difference is $67,450 is the $8,940 and then going from the $89,000 to the $19,700 is going to be taxed at that 22% so if I go back on over to the tax summary over here at the bottom we can see now the ordinary income which is the average tax rate is at the 22% which is basically the tax calculation without this penalty with the $28,521 divided by the taxable income not the gross income but taxable income of $172,300 and that gives us that $16.6 and then the highest rate is the 22% which is you know big difference because of course again there's two people involved for this $200,000 versus the single filer let's go back to the single filer and then just add a little bit more complexity so now I'm going to say they have W2 income but also they've got dividends so dividends have the potential of being taxed at a different rate so if I go to the forms again same $200,000 now we have just Adam Taxman and so the $200,000 and now we've got dividends now I'm going to say they're all qualified we'll talk about that later that brings the taxable income up to another $1,201 standard deduction now back down to $13,850 for the single versus married gives us the taxable income of the $187,150 going to page 2 the tax is calculated at $38,550 now if I go into this worksheet we can see we have a much more you know complex worksheet here and it's like well what is going on this $1,000 right here is throwing a wrench into the system because it could possibly be taxed at different rates other than what we called ordinary income before so if I close this out and I go into for example the tax summary and scroll down so notice we have here the ordinary income tax bracket and that's what they're trying to basically define because they're talking about you know ordinary income versus now you have income that is in that is on the dividends which may be taxed at different rates and we'll talk about that later but I just want to mention it now because when you're trying to explain this to somebody it's going to throw a wrench into the system because you can imagine with the tax planning what is happening is we're saying okay if you make more money in the future you've got to think that you're going to be taxed at the 32 or if you make less money then you're still at the marginal tax at 32 that's the next step that you make however if you go into some of these other categories of income such as capital gains income then it might be taxed at a different rate if it's a favorable rate because you have qualified dividends or something like that so that really throws a fair bit of complexity into the system now because now we have progressive tax rates and then a whole another kind of tax structure for certain types of income and the same is true for capital gains so if you sell stock then the question is how much income are you going to have which is a calculation question in and of itself because you have to subtract what you bought it for and then some of it might be capital gains so if which means it might be a whole another rate again similar to the qualified dividends the idea being that the government wants favorable rates on the investments to try to attract more investments in United States stocks number one and number two with regards to the capital gains it's possible that those gains actually accumulated over multiple years so we'll talk more about the justification or why that might be the case later but that's the idea so which makes sense to but it also is going to add a lot of complexity because now what's going to be the goal of the taxpayer who's trying to pay as little taxes as possible they're going to try to lower their ordinary income to be at the lowest tax bracket and then take advantage of the favorable tax rates that might be offered from other types of income such as possibly dividend income if it's qualified and say capital gains so if they can categorize their income as a capital gain instead of as ordinary income and you're a high income individual then it's likely that you basically could have a significant tax impact which means notice the more complex the code is the more you're going to be paying people like accountants to try to figure these things out to try to do planning where you can make that shift happening the simpler the code is the more people like me don't need to get that you're not paying as much to like the professionals to kind of try to figure that stuff out because it's easy you don't need to do that right so there's a lot of argument in terms of are you actually going to collect more taxes by making the tax code more complex or are you just going to cause people to take greater steps to try to legally pay less taxes by doing more complex planning kind of thing so in any case that's the general rule with the marginal tax rate and the effective tax rate like I say we're just looking at it from a conceptual standpoint right now we'll talk more about each of these line items of the tax equation income adjusted gross incomes and you know the deductions but for now I just want to note that usually what we end up doing is we end up calculating basically the taxable income and we can kind of visualize that calculation in our head because we can see the income statement but then we rely on the software to do the actual tax calculation and therefore a lot of tax preparers don't have a conceptual framework of what the tax calculation is even though it's very significant and has significant impacts on planning in the future because what we're doing is trying to just focus on getting the taxable income basically correct but you want to be able to to kind of understand what the taxes in doing are doing and which tax rates are going to be more or less favorable ordinary income versus other types of income so that when you get into the planning side of things and what not what you should do into the future you could think about the proper estimate of taxes that will happen into the future typically looking at the marginal tax rate as opposed to the average or effective tax rate and also thinking about the concept that you have different things that could be taxed at completely different rates that are not ordinary income rates like possibly qualified dividends for example and capital gains which we'll talk about in future presentations