Understanding how the tax brackets work will aid your tax planning and make for more informed, reasonable discussions of tax policy.
Here are the tax brackets for 2021:
The standard deduction has also been raised for 2021.
People Don't Understand How the Brackets Work
One of the most interesting phenomena I've noticed over the years is that most people don't actually understand how how tax brackets work and they routinely overestimate how much they pay in taxes. For example, I put up a few Twitter polls recently discussing tax brackets. Take a look:
Keep in mind these are not opinion questions.
These questions actually have correct answers that can be easily calculated and, frankly, given how far apart the answers are from each other, pretty easily estimated. It's like asking “Is China closer to Vietnam, Switzerland, Cuba, or Tonga?” Yet only 27-30% of people got the answers right. Sheer random chance would allow 25% of them to get it right. But what is more interesting is that 61-73% of respondents OVERestimated the tax burden.
Why People Don't Get Tax Brackets
There are a few reasons why people can't answer those questions right. Well, not everyone. Rick Ferri was very proud to nail all three.
But most people couldn't estimate the right answer to the questions. I think I know why.
# 1 People Don't Understand the Difference Between Marginal Tax Rates and Effective Tax Rates
If a married couple earns $100K in 2021 and takes no deductions besides the standard deduction, how much will they pay in federal income tax?
Well, first they subtract out the standard deduction of $25,100. That leaves $74,900. The first $19,900 is taxed at 10%, generating $1,990 in tax. That leaves $74,900 – $19,900 = $55,000. That $55,000 all falls within the 12% tax bracket and so is all taxed at 12%. $55,000 x 12% = $6,600. $1,990 + $6,600 = $8,590. $8,590/$100,00 = 8.6%.
There are two key points here. The first is that there is a 0% bracket. Some of your income is not taxed at all. That might be the standard deduction. It might be itemized deductions. There might be some above the line deductions. Whatever. But anything you get a deduction for isn't taxed at all. It's in the “0% bracket”. Some critics on Twitter started pointing out all these other deductions that could be taken. However, all of those would have LOWERED the tax due. This is in essence the MAXIMUM tax paid on that income, not the minimum. So most people still overestimated the tax due even though I used the maximum tax possible in this situation.
The second is simply that being in the 12% bracket does not mean you pay 12% in taxes. You only pay taxes on the money in that bracket. You fill the brackets as you go. Otherwise, you would have paid $12,000 in taxes instead of $8,590. So if you knew someone making $100K was in the 12% bracket, you should know that the answer to the question MUST be less than 12%. There is no reason whatsoever to guess a number higher than that.
# 2 People Don't Understand the Difference Between Taxes Withheld and Taxes Paid
Most people are employees. They don't actually calculate out how much tax they owe and send it in to the IRS each quarter like business owners do. It is just pulled out of their paycheck by their employer before they get it. The newer withholding tables are more accurate than the older ones, but most employees still have more withheld than they actually owe. That's why they get these huge tax refunds every Spring. That is another phenomenon I find interesting—just how bizarrely happy people are to loan money interest-free to their government. But I think it contributes to the idea that people think they pay a lot more in taxes than they do.
# 3 People Don't Know What Federal Income Tax Is
There are also a lot of people who don't know the difference between all of the taxes we pay. Don't get me wrong, there are a lot of taxes. There are state and local income taxes. There are payroll taxes like Social Security tax, Medicare tax, one of the two types of PPACA taxes, and unemployment tax. There are sales taxes and property taxes and gas taxes and inheritance taxes and estate taxes. I guess it should be no surprise that people cannot tell them apart. Several of these are also withheld from their paychecks, such as state and local income taxes and their payroll taxes like Social Security taxes, Medicare taxes, and one of the two PPACA taxes. In fact, some of those payroll taxes (and the other PPACA tax) even show up on their federal income tax return, further confusing the situation.
Most people DO pay significantly more than 8.6% of a $100K income in taxes, but not in federal income taxes. The federal income tax is quite progressive (44% of people pay no federal income tax at all while others have marginal tax rates as high as 37%). However, there are other taxes that are not progressive. My state income tax in Utah is a flat tax, at least once you get past the deductions. Medicare tax is a flat tax, 2.9% on all wage income, half from the employer and half from the employee. Social Security tax is also flat, 12.4% on all wage income, half from the employer and half from the employee, but only up to an income of $142,800. After that it goes to 0% (at least for the employee), thus becoming a regressive tax at upper incomes.
At any rate, people may not realize that the federal tax brackets only apply to federal income tax.
# 4 People Think Everything Taken Out of Their Paycheck Is Tax
Even worse, some people just assume everything taken out of their paycheck before they get it is a tax. Including their retirement account contributions, their share of any life or health insurance premiums, or even court-ordered child support. Sorry, those are good things to pay, but they're not taxes, much less federal income taxes.
I think it is important to understand how our taxes, especially the largest one for most of us—the federal income tax—work. Knowing how they work will help you to better manage your own finances and to actually have intelligent discussions with others about government and tax policies.
What do you think? Why do you suppose most people couldn't answer the questions above correctly? Why is the tax code so mysterious to US citizens? Comment below!
What about the standard deduction for those of us over 65?
It’s a little higher: https://www.kiplinger.com/taxes/tax-deductions/601640/standard-deduction#:~:text=For%202021%2C%20taxpayers%20who%20are,is%20both%2065%20and%20blind.
The biggest issue is that 0% bracket of the standard deduction is not shown. we see only the 10, 12, 22%, etc values. So doing quick estimates points to values near 11% for 100k example. It is a definition problem. You have to define 0% as 0 to $25000, $25001 to 34950, etc. Then it is obvious to the average person that $25000 is not taxed. So the effective tax bracket shrinks. No one will update the chart because standard vs itemized deductions, but the current chart does not explicitly show the non taxed money which explains why people generally overestimate their tax rate.
Aside from the below the line deductions (itemized vs standard) the above the line deductions like 401k contributions etc are also huge.
My personal belief is the United States tax system is too complicated. I disagree with all the convoluted itemized deductions. If the IRS already knows what you owe them, shouldn’t they just send the bill come tax day and be done with it? The reason that does not happen is thanks to the lobby of the tax services here in America.
While I do not agree with the amount of financial literacy required to do well in America, it’s more like if you can’t beat ’em join ’em. The reason most people don’t know how to answer various tax related questions on your Twitter survey is because they use the software systems to enter amounts in an almost infantilized platform. I think there’s a reason TurboTax doesn’t allow you to enter values directly in the various forms – it is a positive feedback loop to driving greater tax financial illiteracy.
I am no tax whiz and have been guilty of using the software in the past with no real understanding of how the calculations were done. That was when I had a lot less time. Now that I am older and with a bit more time to dedicate to my financial literacy, I have suffered through figuring out how marginal tax rates and effective tax rates work. Quite frankly to me ISOs come with some of the most complicated tax implications that affect your decision of if and when to pull the trigger. To me, everything other than ISOs is now well within my understanding. I have yet to own real estate, so I’m not entirely comfortable with real estate taxes yet. That’s a mountain waiting for me.
Long and short of this long winded comment is that I’d recommend filing with a software but also figuring out some of the basic calculations by hand so that you know how the whole system works. If you don’t know, you might overpay. The IRS always accepts tips 😉
My mind boggles at some of the questions you got. My take is: If you are single and make more than about 35k and live in a state with income taxes OR if you are married with or without kids then spend a few bucks on TurboTax or H&R Block tax software for the following reasons:
The interview method they follow is pretty straightforward. It is both a way to get your return done and a way to learn what matters and what doesn’t.
You can and should use your tax software to estimate next years tax due by creating a dummy return with estimated numbers.
Pay attention to this article. Your effective tax rate and where the next income threshold is are what matter most when planning.
If your income changes a great deal up or down, think seriously about working with a CPA for a year or two. It is worth the peace of mind.
I have been doing my own taxes for 50 years. I am not an accountant. I just read the rules an now that we have the internet use http://www.irs.gov for research.
Keep in the back of your mind that the tax prep companies want to scare you into believing you can’t file your own taxes. You can. You might decide it is more cost effective to offload the arithmetic to someone else but you still have to do the scut work of keeping records all year.