 Income tax 2021-2022. Marginal and average tax rates. Get ready to get refunds to the max. Diving into income tax 2021-2022. As we have seen in prior presentations, the federal income tax system in the United States is a progressive tax system, meaning we have different layers involved. We have different tax rates. The rates going up as income levels go up. But we also talked about the idea that progressive can be a term that's going to be relative as well. So in other words, although we would basically categorize the federal income tax system as a progressive tax, we can imagine a tax being more progressive, possibly by having more layers that would be involved or possibly by having bigger increases in the amounts as we go from one layer to the other. We can imagine a tax being less progressive, having less layers involved. We can also use the other term, which is often compared and contrasted, which would be a flat tax. A flat tax being defined as a tax that only has one rate, a flat rate or a pure flat rate, would only have one rate. But if you were to decrease the number of layers, you could say that you're flattening the progressive tax system out in that way. When people use the term flattening, they also mean if they're using it as a favorable term that they're trying to make the tax code easier and when you're making it more progressive, then usually if you're using it in a positive term, you're trying to say you're trying to put the tax burden on people that can afford it on the upper end, but on the negative side, you're also possibly making it more complex. That would be the idea. So now if we apply the rates then, when we talk about what tax rate are you paying, that gets quite confusing as well when you're looking at projections that what should I basically do when projecting into the future as I'm making changes to what my income will be in the future, then what rate should I apply? Should I apply, for example, an average rate? So meaning if I get taxed at multiple different rates, I have to pick an average of it, or should I use basically the last rate, the marginal rate? These are questions we have to ask just from a practical standpoint. And these are questions that many tax preparers don't understand because they only know, really when we do the tax preparation, it's for dependent on the tax software. We're just going to be doing the data input. The data input is going to make the tax return, which is basically an income statement, and then it's going to apply the tax. And we're not going to get into the details of this progressive tax structure. We're going to let the software do that. So when people ask us questions about how much tax am I actually paying on a rate basis, it's a little bit confusing question. If I'm going to make more income next year, how much more am I going to pay? It's going to be confusing because we have this progressive tax system, and we have to understand the concept of an average tax versus a marginal tax to answer those questions. And those numbers will usually be given in tax software. You just need to understand what those numbers are telling you within the tax software and how to apply that as you're discussing it to your own plans or to your clients' plans. So the progressive tax system, you'll recall, is going to have these different layers in it. So let's say we earned a lot of money here. The idea then would be that you're going to be taxed at different levels within it. Now, the misconception that many people have is that if I go up to a different tax bracket, all my income is going to be taxed at that higher bracket. Now, one, that would be kind of not fair. That would be kind of really kind of a big disincentive. So for example, if you were going from the 24 tax bracket and the next dollar you made from 194,925 to 164,926, brings all of your income, all 164,926 to be taxed at 32%, as opposed to 24%. You have a really big incentive, if that were the case, which it's not, to avoid earning that last dollar because it's going to cost you a lot in taxes because all of your income would be taxed. That's not how it works. What's going to happen is that last dollar will be taxed at the 32%. So there's still a disincentive as the progressive tax system goes up, but the disincentive is only on the added dollars that you're earning. So you might say, it's not worth me working any more over and above this income level because the government is taking a higher portion. That could happen if the rates go up a lot at some point, but presumably you still have the incentive to work up to that point. So that would be the general idea of it there. So for example, if you have the 10% bracket, if you earned anything under the 9,950, the 9,950, then you can multiply it times as 10%, it's basically a flat tax up to that point because you only have one layer. But if you earned more than 9,950, somewhere between 9,951 and 40,525, then that first 9,950 times 10% would be the 9,95, which they'll give to you here in the table. Plus you would have to have the difference, whatever the difference was, if you earned 10,000, 10,000 minus the 9,950 plus the 12%, minus times the 12% that you would have to go through. And it actually does that because they're going to use the tax software in tables to help them out with that calculation, but that's the kind of complexity that's in it. So then if you've earned over that in threshold at the 40,526, you're being taxed at three different rates. The first 9,950 that you earned at 10%, everything above that up to the ceiling of 40,525 at 12%, everything up that according to whatever you owed, let's say 50,000, you would then have to calculate the difference at the 22%. So this 4664 then would be what the tax would be up until the 40,526. So in other words, if I was to calculate that, we would say, if let's say we earned 40,526, then on the second tier, it would be 40525 minus the 9951 times the 12% times 0.12 plus the 995 is the 4664, which is the floor or the starting point of this one up until that floor 40,526. So then anything above that, let's say you earned 50,000, you'd have to take 50,000 minus the 40,526, and then they kind of calculated this portion for you. So you take that difference time to 22% and then add this 4664. So that's the idea. Again, no one actually does that because that's a really tedious thing. And it's not only that that you would have to do in practice on the tax return, because there's sometimes when they actually apply a whole different tax rate altogether, such as for like capital gains tax could be at a different rate. For example, dividends could be taxed at a different rate. So when you actually get to the tax calculation, you almost have to be dependent on the computer to calculate it and help you out with that calculation. But then you're going to have questions from your clients saying, well, what am I going to do then next year when I plan to earn more money? What am I going to do in that instance? How much tax am I actually paying? What's the rate that I'm actually paying if I'm paying a progressive income tax system? I would like to know that ratio just so I can understand what is going on here. So for that, you can either use an average tax or you can take a look at the marginal tax rate. So the average tax rate is going to take the total tax, which you're actually paying after you do that calculation, which most people will get from the tax software and divide it by the taxable income. The taxable income being a somewhat confusing term in and of itself because that's going to be the income that you earned minus the deductions that you have basically the income statement, some of which, some of those deductions are not really expenses that you needed to incur in order to generate the income, which you would think would be natural type of deductions. So even that is still a little bit confusing in terms of what you're actually paying based on kind of your income. But that's one method you can kind of say this is my taxable income compared to my tax. For example, if I had total tax of 20,000 that I paid, this is just an arbitrary example just to get the ratio and the taxable income was 100,000. In that case, your average tax would be 20%. Now, the other thing that kind of throws a wrench into this confuses this whole thing is the credits because when you take the credits that are going to be involved, which we'll talk more about when we get to the income tax formula, that also kind of confuses things a bit. So we'll talk more about that later. But for now, we've got the 20%. Now, if you look at the marginal tax rate, then you're just taking the last tax rate that applies. So in other words, if you earned something between 9,951 and 40,525, the last tax rate that was applied to you would be the 12%. The 12% was not the rate that was applied to all the income that you've made, but it's the highest rate that was applied. That's important because if you're making decisions going into the future, you don't want to know the average tax rate, you want to know the marginal tax rate. In other words, if you're doing tax planning or projections for yourself or others and you're saying, hey, I'm going from something, my income is going from like, let's say 40,000 and it's going to go up to 50,000. Well, then you got to know that those last dollars are not going to be taxed at the average tax rate. The average tax rate is an average of what you have paid, but as your income goes up, your tax is going to now be taxed at the highest rate. So you got to look at the highest tax brackets are going to be in. And so that's going to be a really relevant number, important number when people are doing projections. And you want to be careful with that. So if people ask you the general question, I just want to know, what's my average tax that I'm basically paying? Just so I know how much I actually pay. Well, that's going to be the average tax. But if I want to know, hey, look, I expect to make more money next year, what's going to be the impact on the margin? And that's an economic term from economics on the margin always means basically what's the pros and cons of the next step? I'm already here. What about the next step? What's the next step going to do? Well, the next step, if you're already at this tax bracket, it's not going to be taxed at the average, which will always be lower. It'll be taxed at your highest tax bracket or higher, depending if you're going up to a higher tax bracket. So you got to understand the difference between those two. We'll take a little look at it in income tax software later, but just from a formula standpoint, this is just the income tax formula. In Excel, we'll talk more about it later, but let's say you just had income of 100,000 and we only had the standard deduction of the 12-5-5-0. So that would give us the taxable income of the 87-450. That's usually what people kind of double check in the tax software. That's what you can get from your data form, your W-2 and whatnot. And then you often rely on the tax software to calculate the actual rate, which is the progressive tax system. It's applying tables and the progressive tax system. Once it does that, then you can say, okay, well, what's my actually tax? If it was the tax was 15,015, then I can see my average tax would be this taxable income divided by the taxable income would give us the average tax. And so you can kind of figure out the average tax that way. But from a projection standpoint, you want the marginal tax. And we'll talk more about this in the software later, but if you look at software, this is in LASERT, then it'll typically give you, here's your 1040. We'll talk more about this in a future presentation, but here's your 1040. And then if you were looking like a tax summary, most software has some kind of tax summary, which will give you kind of a side-by-side from the prior year. I don't have anything in the prior year, but they give you these items down below. The marginal tax rate is the highest tax rate that was applied out here. And then the effective tax rate is the average tax rate. So if someone is asking, you know, how much did I pay on average? Well, you could explain the calculation, but we're talking 17.2%. The marginal tax rate, what's the highest tax bracket? What am I going to be paying taxes on if I earn more money in the future? 24 is your current marginal tax bracket. And if you go above a certain level, you'll be going up above and paying the next bracket up. And usually tax softwares in the diagnostics and in the analysis will tell you when they will hit that next level or the next tier so you can appropriately give some advice in terms of what earnings might do in the future.