 Income tax 2022-2023. Marginal and average tax rates. Let's do some wealth preservation with tax preparation. In a prior presentation, we discussed what a progressive tax is versus a flat tax system, the United States income tax being a progressive tax system, one that has multiple tiers, multiple layers. And as the income goes up, the rates go up, which could lead to having multiple rates basically being applied when we calculate the tax based on one taxable income amount. A calculation which is clearly more complex than a flat tax, where we would only be multiplying times one rate. And it also leads us to want to be able to summarize those rates. Support Accounting Instruction by clicking the link below, giving you a free membership to all of the content on our website, broken out by category, further broken out by course. Each course then organized in a logical, reasonable fashion, making it much more easy to find what you need than can be done on a YouTube page. We also include added resources such as Excel practice problems, PDF files, and more like QuickBooks backup files when applicable. So once again, click the link below for a free month membership to our website and all the content on it. And one number which leads to the concepts we're talking about now, which is the average tax and the marginal tax. These are important terms we would like to be able to calculate for a client and provide to the client and tell them the relevance of those terms. To understand that, let's recap what the progressive tax system is and how that leads to the complexity and the problems that lead us to what these numbers, an average tax and a marginal tax. So this is the 2023 single file or tax brackets. We'll talk more about the tax bracket, basically different calculations for statuses such as buried filing joint or single or head of household later. But this is just to get us an idea of the progressive tax system. So we have these tiered levels. So if they have 11,000, we're taxed at the 10%. Now remember, this is the complexity of just calculating the actual tax now. That means we're calculating it based on the taxable income. We'll talk more about the tax formula, which gets into what should we include in income, what should be included in the deductions and how do we get to the taxable income. We'll talk more, we'll dig into that later. But assuming we get there, then we're going to be just calculating the tax. We want to understand what that tax calculation is. We also have complexity with regards to credits that we have to deal with as well. So all of these, of course, put further complexity into the tax code. So then if you earn over 11,000, but not over 44,725, now you're applying the 12% tax not to the entire amount. Let's imagine you earn 44,725, you wouldn't suddenly go from 10% to just a flat rate of 12%. That would be easier to calculate actually, but it would be kind of unfair because you can imagine then if someone jumped from 11,000 to 11,000 and $1 that you would suddenly tax them from 10% to 12% doesn't seem quite right. So what should happen is you're taxing the first layer at the 10% and that's calculated here with the 1100 for us in this table. And then the rest of the tax will be taxed at 12%. And if you made over 44,725, but not over 95,375, this 5,147 is basically summarizing the 10% at the 11,000, the difference between the 11 and the 44,725 at the 12% and then the difference between whatever you earned up to 95,375 and the 44,725 which is now taxed at 25% and so on and so forth as we increase in the layers. So the tax calculation gets more and more complex as we add the layers. Now in practice, this isn't that complex for us to do the tax return because we just use the tax software which applies the table calculation or something or a calculation like this in order to spit out the answer. So we're like, no worries to do that. However, it's still kind of an issue when you're explaining this to a client. They're like, well, how much tax did I actually pay and what you don't want to have to tell them? Well, you know, you paid 10% on the first 11,000 and then you paid and then you paid like 12% on the amount of your income or your taxable income, not your gross income, but your taxable income from 11 to 44,725 and then the amount that was from the 44,725 up to the 75,375 you paid 22%. But then you had credits actually that were applied after that that brought it down and so it gets quite muddied up. So what you would like to be able to do is say, well, there's a progressive tax system, multiple tax were applied, but this is one number that summarizes those taxes. Usually when we think of one number that summarizes a group of numbers, we think about an average. It would be an average. This is your average tax rate. Now, the average tax rate will work. It'll be a good tax rate to use to give someone, but it's not the best rate to use for planning into the future because if they're trying to say, hey, look, next year, I'm going to earn more money, how much tax am I going to owe? You can't base that on the average tax rate because that's pulling it's going to be lower because they're going to be taxed at the margin. That's an economic term at the margin. So that's why the marginal tax rate, their top tax bracket is important for planning. So let's just do a look at that in a little bit more detail. If I was to just take their total tax, so let's say that we did their tax return and they and we got their total tax. If I take their total tax divided by the taxable income, which again is a complicated number in and of itself because the taxable income took into consideration the gross income minus the deductions. And then you also have credits that complicate this, the idea of these conceptually. But tax income divided, the total tax divided by the taxable income, meaning the software calculated the tax using the complicated multiple rate table divided by the taxable income gives us the average tax. So I'm going to say, yeah, it's a progressive tax system. But this is basically one number that encapsulates that list of numbers that you dealt with. And that's that's a good number to give someone for that average tax. So a calculation like if you had 20,000 divided by 100,000 total tax divided by 100,000, that would be 20%. Right. And you can this is just an example, which is that's that's going to be it. That's your average tax, even though we know in actuality, it was multiple tax, it was multiple rates. So and then the marginal tax, though, the problem with this average tax, again, it's kind of like you're trying to give someone number like average what they're paying on the taxes. But it's not really going to help you for the budgeting into the future, because if they say, I'm going to earn more money next year, or I'm going to earn less money next year, then we're not diving back into this 10%. They're probably not going to be dipping back into this 10%. We're talking about the margin. So if they were, if they were in this category, if they were in the 24% category and they earned more money that was going to be somewhere within this category, if I gave them the average, it would be too low, right? And let's just take a quick look at that. If I know this isn't the way you generally calculate the average because you'd be taking a quick look at the taxable income once again. I'm sorry, the tax divided by the taxable income. But if I just, I did the average this way by just looking at like, okay, I'm just going to take those four rates divided by four and say, okay, that's going to be 0.1, 0.12, plus 0.22, plus 0.24 divided by four. Then I could say, ah, your average rate is like 17, right? I took those four numbers added them together and divided by four to get the average. But again, in practice, what you would be doing is taking the taxable income, which was calculated by the software divided by, I'm sorry, the tax that was calculated by the software divided by the taxable income. But just as an example, if I was to say, if that was your average and you think you're going to make another 50,000 next year, I can't just say, well, yeah, take that 17% times 50,000, it's going to be too low because you're working at the margin. So from an economic standpoint, the next step you make, you have to think about what's going to be the impact from this point going forward. And if you are currently in the 24% tax bracket, then the next dollar you're going to be taxed on isn't going to be at the average, it's going to be at the max, it's going to be at the high end, it's going to be at what we call the marginal tax rate. So when you deal with tax planning, you got to think, okay, if they have more, if they earn more now that I have this progressive tax system, you would think that that would be impacted at their highest tax rate unless they go earn enough to get into the next tier up. So now we've got to worry about, well, when are they going to hit the next tier up? We're not worried about it because we're going to say, hey, look, if you go over 95, if you go over 181-100, if you earn 182-100 and $1, you're going to suddenly be taxed at 32%. That's not the concern, no. But the concern is that you're going to be paying taxes at 24 to 32 on the added dollars, not at 17%, the average rate. So if you give them the average rate, you're going to make estimates that are way low, and that, of course, will cause people to be mad at you because they're going to owe money in the following tax years. So it's really important two terms to give them. Most tax salts, where as we'll see in a following presentation, will give you these two rates, the marginal tax rate and the average tax rate. And those are two things that you might want to emphasize with a client as you're talking to them. If you're doing bookkeeping, telling them what the average is, you can say, yeah, that's the average. That's what you average pay. But that's not really the most useful term when you're trying to make decisions about changes to your taxes in the future because the changes are made, the decisions are happening at the margin. And that means you're making decisions at the highest rate.