Your Taxes May Be Lower Than You Think

I recently had a discussion (debate) with a friend of mine comparing the benefits of pre-tax investments to those of Roth investments. I argued that, while there are many cases where Roth investing would be more advantageous/practical for the average person, pre-tax is usually the best choice mathematically. I presented him with several supporting facts and figures (many of which are mentioned in my post about the greatness of 401(k)s) but we were never able to reach an agreement on which was the better option. I decided, for my next post I would run the numbers and come up with a definitive winner. As I began to put an outline together for the post, I realized I would need to do some detailed tax calculations in order to come to an accurate conclusion.

Typically, when creating an example involving taxes, I simply select a marginal tax rate and apply it across the total income. In reality, however, Federal income taxes don’t work this way. Thinking about this made me realize that most people are probably unfamiliar with exactly how Federal income taxes are calculated. Since knowledge of how income taxes are calculated is crucial to understanding any pre-tax vs. Roth comparison, I decided to temporarily shift gears and write an article explaining our tax system. The pre-tax vs. Roth debate will have to remain unanswered for at least another week. Anyway, on to taxes…

If Mary is unmarried and has an income of $100,000 per year, she will fall into the 24% tax bracket. However, as a result of our progressive tax system, her effective tax rate (the percent of her income she actually pays in taxes) will be significantly lower. Mary’s $100,000 income will be taxed as follows:

The first $9,525 will be taxed at 10%

The next portion of her income—above $9,525, but not $38,700—will be taxed at 12%

The next portion of her income—above $38,700, but not $82,500—will be taxed at 22%

The final portion of her income—above $82,500, but not $157,500—will be taxed at 24%

Now let’s work it all out,

Income Taxed At 10% = $9,525 x 10% = $952.50
Income Taxed At 12% = ($38,700 - $9,525) x 12% = $29,175 x 12% = $3,501
Income Taxed At 22% = ($82,500 - $38,700) x 22% = $43, 800 x 22% = $9,636
Income Taxed At 24% = ($100,000 - $82,500) x 24% = $17,500 x 24% = $4,200

Total Income Taxes Owed = ($952.50 + $3,501 + $9,636 + $4,200) = $18,289.50
Effective Tax Rate = $18,289.50 / $100,000 = 18.29%

Even though her tax bracket is 24%, Mary only owes 18.29% of her income to taxes.

Let’s do an example for married filers.