Saturday, January 24, 2015

How Do Tax Rates Work?

income tax
When you get your paycheck, you are probably mostly interested in what you can spend.  On closer examination, what you get is really what is left over after various expenses have been deducted.  One of those expenses is tax.  Tax is an expense like any other expense and you do have some control over how much you pay.  More about that in other posts.

Let us take a look at how it is calculated.  Here is a really simple example:

Annual income:  30,000
Personal exemption: 6,300
Tax rates:  <9,225 = 10%, 9,226 - 37,450 = 15%

Not all income is taxable.  The personal exemption excludes the first 6,300 from taxation.  That leaves 23,700 (30,000 - 6,300) as taxable income.

The next 9,225 is taxed at the rate of 10%, so that will be 922.50.

The remaining 14,475 (23,700 - 9,225) is taxed at the rate of 15%, so that will be 2,171.25.  That makes the total tax 3,093.75.

So what is your real, or effective, tax rate then?  I is calculated like this: Tax divided by total income multiplied by 100.  In our case above, it becomes 3,093.75/30,000*100 = 10.3125%.

This is a useful number to know when you make a budget.  You can treat tax as just another expense item.  The more money you make, the higher the effective tax rate. The higher the rate, the more important it is to pay attention to it.

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