How do taxes in America really work?

A few weeks before the presidential election, my friend Ted sent me a link to a YouTube video that had a strong political bias. Since I’d never known Ted to be a particularly political guy, I started watching out of curiosity just to see what he’d found so intriguing.

The gist of the video was that if the other side’s candidate for president won, you should hold on to your wallet. Taxes were going to go sky high. But is that true?

How do taxes in America really work?


I’ve been thinking about this video since I saw it. It’s a good topic to post to the website because it gives the perfect opportunity to talk about how taxes in America work.

Hold onto your wallet? Uh, wait a minute.

Many of the savings and investment decisions we make together have tax implications. So, the more you know about how the tax system works, the more you’ll be able to think through those decisions.

For as long as I have been in the investment business, and for a long time before that, there have been tax brackets. The idea is that as your income goes up, the higher tax rate you pay.

But even before we get to how that works, let me talk a bit about two other key tax terms — gross income and taxable income.

Gross income is simply the sum of all of your income. If you’re working, you earn income from your job. If you’re retired, you may receive a pension. You may be taking withdrawals from a retirement plan such as an IRA or a 401(k). Perhaps you have rental income. If you have savings and investments, you may receive interest and dividend income. Add all of these up, and you have your gross income.

Taxable income is what you have when you reduce your gross income by any deductions you may have. Deductions include things such as personal exemptions granted by the IRS, interest on your home mortgage, certain medical expenses, property taxes, charitable contributions and the like. Once you know your taxable income you can calculate the tax you owe.

Tax on $250,000 would stay the same.

I mentioned that historically as taxable income increases so does the percentage of tax that you pay. As your income rises you move from one rate, or bracket, to another.

The first bracket is 10%. It applies to taxable income up to $17,400 for a married taxpayer filing jointly this year. Each and every one of us pays 10% of the first $17,400 of taxable income we have regardless of how much taxable income we have. The total could be $25,000, or $250,000, or $2.5 million. Regardless, the first $17,400 would always be taxed at 10%.

The video Ted sent me said that there is a proposal to increase tax rates by 5%. It went on to say that if that increase passed, a taxpayer earning $250,000 per year would see his tax bill increase by $12,500. That would be true if there was a proposal to increase each tax bracket by 5%. But that’s not the case. The proposal is to increase taxes on taxable income over $250,000.

So, if you have taxable income of $250,000 — that’s income after all of your allowable deductions — your tax would be exactly the same even if the proposed increase were passed. Why? You have no taxable income over $250,000. The tax on the brackets up to that sum wouldn’t change.

What if your taxable income is $251,000?

Then your total tax, if the proposed increase were passed, would be $50 more than before the increase.

  • Only $1,000 would be subject to the increased tax rate.

If you are fortunate enough to have taxable income of $260,000, then $10,000 would be subject to the increased bracket. The tax would be $500 more under the proposed new law than the current law.

All of these scenarios are far less severe than simply saying that if tax rates go up by 5% a person with income of $250,000 will see their tax jump by $12,500. That’s just not the case.

There are a couple of messages here.

  • First, try to understand, if not specifically then conceptually, how tax laws in America work. It’s to your advantage in making good decisions.
  • Second, don’t fall for scare tactics brought out by one political party or the other. Folks play fast and loose with facts all the time, especially at election time or when the government has to make important decisions, such as the “Fiscal Cliff” issue looming at the end of this year.

If this post, or any others on my site, piques your interest and you’d like to discuss it further, give me a call. After we talk taxes for a bit we can talk about Formula One racing or racquetball, both of which are discussed in other posts that you may want to read. They’re definitely more fun than taxes.