Trying to understand the 1040 Tax Table

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Faith20879
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Trying to understand the 1040 Tax Table

Post by Faith20879 »

Dear BHs,

While explaining the Tax Table to a friend, a question came up.

We started with the tax brackets and tax rates (10%, 15%, 25% and so forth), no problem there. Then we got to the Tax Table where each increment of 50, the tax amount is listed - for each filing status with less than $100,000 taxable. The taxes can be translated into rates in the range of 11%, 12%, 13%, ..., 17% by dividing the amount by the lower (or upper) bound. http://www.irs.gov/pub/irs-pdf/i1040tt.pdf

Is there an official name for this rate? I don't want to keep calling them the "rates in the Tax Table" if it has an actually name.

Thanks,
Faith
JohnFiscal
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Re: Trying to understand the 1040 Tax Table

Post by JohnFiscal »

I think I'd call that the "effective total tax rate". But I don't pay any attention to that number.
Novine
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Re: Trying to understand the 1040 Tax Table

Post by Novine »

I was going to go with "effective tax rate" too. But some Googling around found that the term "effective tax rate" means something similar but more than just the calculation using the tax table.
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Peter Foley
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Re: Trying to understand the 1040 Tax Table

Post by Peter Foley »

If you use Turbo Tax and run multi-year comparisons, it will list your current year tax rate (11.25% for example). They refer to it as your "effective tax rate".
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Faith20879
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Re: Trying to understand the 1040 Tax Table

Post by Faith20879 »

Got it! "Effective Tax Rate"

Thanks!
jasc15
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Re: Trying to understand the 1040 Tax Table

Post by jasc15 »

JohnFiscal wrote:I think I'd call that the "effective total tax rate". But I don't pay any attention to that number.
Can you elaborate? Why does your marginal rate matter, when what you pay is this "effective" rate?
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Re: Trying to understand the 1040 Tax Table

Post by The Wizard »

jasc15 wrote:
JohnFiscal wrote:I think I'd call that the "effective total tax rate". But I don't pay any attention to that number.
Can you elaborate? Why does your marginal rate matter, when what you pay is this "effective" rate?
Because: some of us (in retirement mostly) have the option of taking more income in a given year, to help buy a car or do a Roth conversion, for instance. That money taken from your IRA will be taxed at your marginal rate.

Conversely for the working class, putting another $100 into your trad IRA or 401(k) this year will REDUCE your tax owed by the marginal rate percentage...
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The Wizard
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Re: Trying to understand the 1040 Tax Table

Post by The Wizard »

Note however, that the Tax Table is just an approximation to your true marginal tax rate.
Certain deductions PHASE OUT through a range of income, so your true marginal rate could be higher (never lower?) than the Table.
You need to run tax software on your own specific details to determine this...
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JohnFiscal
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Re: Trying to understand the 1040 Tax Table

Post by JohnFiscal »

jasc15 wrote:
JohnFiscal wrote:I think I'd call that the "effective total tax rate". But I don't pay any attention to that number.
Can you elaborate? Why does your marginal rate matter, when what you pay is this "effective" rate?
Others have answered and I'll toss in my opinion.

The marginal rate matters greatly. Because this is the rate at which any additional income that you might gain will be taxed.

In other words, say your taxable income is $50,000 and your marginal rate is 15% (I'm just making these numbers up and they may not reflect the actual tax tables). Then at the end of the year you get a bonus that puts you into the 25% tax rate...your bonus is now taxed at 25%. All attempts at tax minimization are focused on minimizing/reducing the marginal rate.

Then again, two people might have identical incomes in terms of dollars (but not sources). Maybe one has more deductions and gets taxed at a lower rate on dividends. So "his" effective tax rate will be less than the first "guy". Quirks of the tax code. Tax payer's role is to minimize their effective tax rate by utilizing legitimate tax dodges such as itemizing deductions, postponing income (IRA, 401K, delayed bonus), and minimizing their marginal tax rate.
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Re: Trying to understand the 1040 Tax Table

Post by JohnFiscal »

In fact, the true effective tax rate should be based on your true total income...before all those deductions, etc.
Bob's not my name
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Re: Trying to understand the 1040 Tax Table

Post by Bob's not my name »

The Wizard wrote:Certain deductions PHASE OUT through a range of income, so your true marginal rate could be higher (never lower?) than the Table.
Besides deduction phaseouts, there are also taxes, tax credits, and exemptions that phase out. Furthermore, these are not based on taxable income, but on other income definitions, such as AGI, MAGI, wages, etc. Some examples: http://thefinancebuff.com/your-marginal-tax-rate.html

So the tax tables are inadequate for most people.
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Re: Trying to understand the 1040 Tax Table

Post by dickenjb »

Effective tax rate, while interesting, is useless for decision making. All decisions to recognize additional income or accelerate deductions are based on the marginal rate.
earlyout
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Re: Trying to understand the 1040 Tax Table

Post by earlyout »

The tax you calculated from the tax table is just a combination of the various marginal rates on regular income. Depending on how much regular taxable income you may have, some of that income is taxed at 10%, some at 15%, some at 25%, etc. Using the table replaces a calculation where you would use the different marginal rates for each tax bracket.
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Re: Trying to understand the 1040 Tax Table

Post by JohnFiscal »

yah, hey. Nobody ever gets taxed on their effective tax rate. They get taxed on their marginal rate (and the floor below).
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Re: Trying to understand the 1040 Tax Table

Post by placeholder »

dickenjb wrote:Effective tax rate, while interesting
I don't even find it particularly interesting and I have never computed it or asked my tax software to display it.
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Epsilon Delta
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Re: Trying to understand the 1040 Tax Table

Post by Epsilon Delta »

The tax tables exist simply because a long time ago we had to do arithmetic by hand. Since most people are bad at arithmetic this raised the error rate on tax returns to an unacceptable level. So the IRS pre-performed the calculations need by 99% of the population and put them in tax tables.

Now that we have calculators, and excel, and turbotax; you* can ignore the ignore the tax tables, as they do not add any insight into the tax system.

*Unless you're writing tax software, in which case you have to duplicate the tax tables exactly. When I did this many years ago the federal tables obeyed simple rounding formula, so I could calculate them on the fly without having a 300kbyte table fill the entire disk. On the other hand some of the states had tables that defied formulas, I think they used random rounding.

Edit s/defined/defied/
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dbr
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Re: Trying to understand the 1040 Tax Table

Post by dbr »

dickenjb wrote:Effective tax rate, while interesting, is useless for decision making. All decisions to recognize additional income or accelerate deductions are based on the marginal rate.
Exactly. Marginal rate is useful for comparing decisions between or among alternatives, all else being equal. Effective rate tells you what taxes are costing you overall. When you see your effective rate it might or might not provoke research into means of becoming more tax efficient or at least taking into account what your costs really are.
scrabbler1
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Re: Trying to understand the 1040 Tax Table

Post by scrabbler1 »

Faith20879, if you want to see how the tax brackets work their way into the tax tables, look at the tax liabilities for two income amounts $1,000 apart. Make sure the two income amounts do not straddle a tax bracket's end point. If they are in the 15% bracket, for example, then the tax amounts will be $150 apart.

I have a homemade spreadsheet which mimics a tax form including the income taxed which come from the tax table. I am able to convert the income amount to the midpoint of the $50 range then calculate the taxes due based on that adjusted income amount. That amount matches the tax shown in the tax table.
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Re: Trying to understand the 1040 Tax Table

Post by jasc15 »

dickenjb wrote:Effective tax rate, while interesting, is useless for decision making. All decisions to recognize additional income or accelerate deductions are based on the marginal rate.
There is a dichotomy in my head on this issue. On one hand, I see that reducing taxable income by one dollar, you will save tax equal to the marginal rate on that dollar. On the other hand, if my marginal rate is 25%, and my effective rate is 17%, couldn't I correctly say that every dollar is taxed at 17%?
gerrym51
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Re: Trying to understand the 1040 Tax Table

Post by gerrym51 »

our goal in retirement is always to stay in 15 percent tax bracket(always have too much income for 10 percent) we always arrange to stay outof 25 percent so only interested in 25 percent threshold
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Phineas J. Whoopee
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Re: Trying to understand the 1040 Tax Table

Post by Phineas J. Whoopee »

jasc15 wrote:...
There is a dichotomy in my head on this issue. On one hand, I see that reducing taxable income by one dollar, you will save tax equal to the marginal rate on that dollar. On the other hand, if my marginal rate is 25%, and my effective rate is 17%, couldn't I correctly say that every dollar is taxed at 17%?
You could correctly say that on average the dollars are taxed at 17%, if that's useful for you to know. I sort of like knowing it myself.

The main point is, however, it doesn't tell you how the next dollar (or deduction) will change your tax. In your example, using your marginal rate you will predict that dollar to net you $0.75. Using your effective rate you would predict $0.83. The first is true, the second is not.

Now, what if it were not one dollar, but $10,000, without changing a bracket? Now the difference in after-tax proceeds from what's true, $7,5000, to what isn't, $8,300, is eight hundred bucks, which isn't chump change to me and could well affect a decision.

The marginal rate tells you the tax impact of the thing you're thinking of doing, and should be one of the criteria when deciding whether to do it.

PJW
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Re: Trying to understand the 1040 Tax Table

Post by RustyShackleford »

scrabbler1 wrote: I have a homemade spreadsheet which mimics a tax form including the income taxed which come from the tax table. I am able to convert the income amount to the midpoint of the $50 range then calculate the taxes due based on that adjusted income amount. That amount matches the tax shown in the tax table.
Yep, I have a similar spreadsheet; I take my taxable income, or rather the part of it taxed at the ordinary rate (excluding QDI and LTCG), lets say it's in cell D46, and apply the function FLOOR(D46,50)+25. Then I just apply the usual computation (the same one used if your taxable income is above the range covered in the tables) to the result. As an aside, I am cynically amused at the politicians who like to justify a flat tax as "simplifying the tax code"; yeah right- if your income is so high that it's not in the tax tables, AND if you don't use Turbotax, AND if you don't use an accountant, yes, it saves you a feverishly complex calculation that involves one subtraction, one multiplication, and one addition.

I call my spreadsheet "estimated taxes"; it's a little complicated to set up the first time, but then you just do minor tweaks each year. I use it ALL the time in tax planning. In particular, I use in to figure out how much tax-gain harvesting and/or Roth conversion to do to "fill" the 15% tax bracket (so I am having as much money as possible taxed at that relatively low rate, while having none taxed at the higher 25% marginal rate). I can also dial in on how much withholding and estimated-taxes to do, to avoid penalties, and in particular to pay as little state tax as possible in standard-deduction years (as part of a deduction "bunching" strategy) while avoiding underpayment penalties.
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Re: Trying to understand the 1040 Tax Table

Post by scrabbler1 »

RustyShackleford wrote:
scrabbler1 wrote: I have a homemade spreadsheet which mimics a tax form including the income taxed which come from the tax table. I am able to convert the income amount to the midpoint of the $50 range then calculate the taxes due based on that adjusted income amount. That amount matches the tax shown in the tax table.
Yep, I have a similar spreadsheet; I take my taxable income, or rather the part of it taxed at the ordinary rate (excluding QDI and LTCG), lets say it's in cell D46, and apply the function FLOOR(D46,50)+25. Then I just apply the usual computation (the same one used if your taxable income is above the range covered in the tables) to the result. As an aside, I am cynically amused at the politicians who like to justify a flat tax as "simplifying the tax code"; yeah right- if your income is so high that it's not in the tax tables, AND if you don't use Turbotax, AND if you don't use an accountant, yes, it saves you a feverishly complex calculation that involves one subtraction, one multiplication, and one addition.

I call my spreadsheet "estimated taxes"; it's a little complicated to set up the first time, but then you just do minor tweaks each year. I use it ALL the time in tax planning. In particular, I use in to figure out how much tax-gain harvesting and/or Roth conversion to do to "fill" the 15% tax bracket (so I am having as much money as possible taxed at that relatively low rate, while having none taxed at the higher 25% marginal rate). I can also dial in on how much withholding and estimated-taxes to do, to avoid penalties, and in particular to pay as little state tax as possible in standard-deduction years (as part of a deduction "bunching" strategy) while avoiding underpayment penalties.
The formula in my spreadsheet is similar to yours. It is @ROUND((AM47+25)/50,0)*50-25. It figures out the midpoint of a $50 range where cell AM47 is the actual income amount.

My spreadsheet also enables me to a lot of what-if scenarios. I expanded one spreadsheet to show me the 2-year effect of bunching deductions. To make things easy to update from year to year, I make sure the tax brackets as described in the tax booklet are external inputs, not edits to cells in a formula.

I agree with your aside about the pols and their flat tax proposals to simplify the tax code. The complication is in determining the taxable income, not in figuring out the tax on said income.
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Re: Trying to understand the 1040 Tax Table

Post by rkhusky »

Marginal tax rate is useful for some decisions. Effective tax rate is useful for others. As an example of the latter, consider the Roth vs Traditional decision. While you typically get a tax break at your marginal rate when contributing to a Traditional Account, if you have no other sources of income, your withdrawals are taxed at your effective rate.
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Re: Trying to understand the 1040 Tax Table

Post by Epsilon Delta »

rkhusky wrote:Marginal tax rate is useful for some decisions. Effective tax rate is useful for others. As an example of the latter, consider the Roth vs Traditional decision. While you typically get a tax break at your marginal rate when contributing to a Traditional Account, if you have no other sources of income, your withdrawals are taxed at your effective rate.
No, you should use marginal rate at both ends. It gets the correct result in all cases. In the case of no other income the marginal rate is zero so you get the same result. On the other hand effective rate only ever gets the correct result if you apply special conditions. Special conditions which you can only figure out by using the marginal rate.
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Re: Trying to understand the 1040 Tax Table

Post by RustyShackleford »

Yep, I have a similar spreadsheet; I take my taxable income, or rather the part of it taxed at the ordinary rate (excluding QDI and LTCG), lets say it's in cell D46, and apply the function FLOOR(D46,50)+25.
The formula in my spreadsheet is similar to yours. It is @ROUND((AM47+25)/50,0)*50-25. It figures out the midpoint of a $50 range where cell AM47 is the actual income amount.
I think my formula is more straightforward ! (Just kidding, silly to have a pissing contest over two formulae that give the same result, but hey, this is the internet).
My spreadsheet also enables me to a lot of what-if scenarios. I expanded one spreadsheet to show me the 2-year effect of bunching deductions.
Yeah, it's great. On bunching though, I see no downside. Just push as much stuff as possible into the "itemized" years. The trickiest part is minimizing state taxes paid in the "standard" years, without getting in too much trouble; probably actually makes sense to even suffer an underpayment penalty, but I think they can actually penalize you beyond that for willful underpayment.
To make things easy to update from year to year, I make sure the tax brackets as described in the tax booklet are external inputs, not edits to cells in a formula.
Oh yeah, I just have a separate little box off to the side, where I enter the various federal and state brackets, exemptions, etc.

Some fun, at least for those of us who enjoy messing with Excel (aka. geeks).
Last edited by RustyShackleford on Thu Aug 28, 2014 8:10 pm, edited 1 time in total.
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Re: Trying to understand the 1040 Tax Table

Post by LadyGeek »

This thread is now in the Personal Finance (Not Investing) forum (taxes).

Here's more info: Marginal tax rate
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Re: Trying to understand the 1040 Tax Table

Post by scrabbler1 »

LOL Rusty, I use Lotus2000 for many of my spreadsheets. I do know how to use Excel, too, I just prefer Lotus because I used that in my formative years of my working career. The formula I posted is a Lotus one.

As for bunching, there is a downside to bunching, as I have figured out from my handy-dandy spreadsheet. I have two items which together may make bunching unprofitable for me. The first is I get a state property tax rebate the year after I pay the property taxes which has to be counted as income if I itemize my deductions, among them my state and local taxes paid. The second is that I have my health insurance through a state-run exchange as part of the ACA and qualify for a federal subsidy to offset part of the premium. If I try to bunch my deductions which include state and local taxes paid, I have to include the tax rebate a year later. The rebate counts as income (MAGI) and that reduces the federal subsidy. Therefore, what I gain from bunching the deductions on the income tax side I then lose on a reduction in the subsidy.

It may pay to simply take the standard deduction the whole time (which would make my tax returns a lot easier) and forgo any bunching. I would like to see what the 2014 Form 1040 looks like before the end of this year so I can fine tune the spreadsheet to match it.
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Faith20879
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Re: Trying to understand the 1040 Tax Table

Post by Faith20879 »

scrabbler1 wrote:I have a homemade spreadsheet...
This inspired me!

I've just finished my 2014 tax worksheet and am now doing the 2019 projection. The concept of "bundling" is new to me but I am gradually seeing the logic in it. Wow, now I can play with all kinds of scenarios and see how the Roth conversion may benefit. I love it!

Thanks to all!
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Re: Trying to understand the 1040 Tax Table

Post by rkhusky »

Epsilon Delta wrote:
rkhusky wrote:Marginal tax rate is useful for some decisions. Effective tax rate is useful for others. As an example of the latter, consider the Roth vs Traditional decision. While you typically get a tax break at your marginal rate when contributing to a Traditional Account, if you have no other sources of income, your withdrawals are taxed at your effective rate.
No, you should use marginal rate at both ends. It gets the correct result in all cases. In the case of no other income the marginal rate is zero so you get the same result. On the other hand effective rate only ever gets the correct result if you apply special conditions. Special conditions which you can only figure out by using the marginal rate.
That is incorrect. If I withdraw $100,000 from my traditional IRA, with no other income, my marginal rate is likely not zero.

In this case, I would have saved $25K by using the traditional IRA (with a marginal rate of 25%), which I could have invested. If my effective rate on this withdrawal is 10%, I pay $10K in taxes now. The use of a Traditional account was a better choice for these funds than a Roth. The marginal rate on this withdrawal is immaterial - it doesn't matter whether it is 15% or 25%, what matters is the effective rate of 10%.
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Re: Trying to understand the 1040 Tax Table

Post by Kosmo »

rkhusky wrote: That is incorrect. If I withdraw $100,000 from my traditional IRA, with no other income, my marginal rate is not zero.

In this case, I would have saved $25K by using the traditional IRA (with a marginal rate of 25%), which I could have invested. If my effective rate on this withdrawal is 10%, I pay $10K in taxes now. The use of a Traditional account was a better choice for these funds than a Roth. Whatever the marginal is now is largely immaterial.
I think the problem is that you only know your effective rate after the fact, whereas marginal is a known number. What if you only withdrew $80,000, but still owed $10,000 in taxes? (Taxable income is constant.) Now your effective rate is 12.5%, but your marginal rate could stay the same. The useful thing in this situation is marginal rate.
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Re: Trying to understand the 1040 Tax Table

Post by rkhusky »

Kosmo wrote:
rkhusky wrote: That is incorrect. If I withdraw $100,000 from my traditional IRA, with no other income, my marginal rate is not zero.

In this case, I would have saved $25K by using the traditional IRA (with a marginal rate of 25%), which I could have invested. If my effective rate on this withdrawal is 10%, I pay $10K in taxes now. The use of a Traditional account was a better choice for these funds than a Roth. Whatever the marginal is now is largely immaterial.
I think the problem is that you only know your effective rate after the fact, whereas marginal is a known number. What if you only withdrew $80,000, but still owed $10,000 in taxes? (Taxable income is constant.) Now your effective rate is 12.5%, but your marginal rate could stay the same. The useful thing in this situation is marginal rate.
If I know my deductions and income and have the tax forms, I can just as easily determine my marginal rate as I can my effective rate. Marginal rate can actually be very tricky to determine. For example, when dealing with the child tax credit, $1 in extra income can result in an increase of $50 in taxes, i.e a marginal rate of 5000%.

If my total tax on a $100K withdrawal was $10K, I would think it very strange that a $80K withdrawal would also result in a $10K tax bill.
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Re: Trying to understand the 1040 Tax Table

Post by rkhusky »

The Wizard wrote:That money taken from your IRA will be taxed at your marginal rate.
dickenjb wrote:Effective tax rate, while interesting, is useless for decision making. All decisions to recognize additional income or accelerate deductions are based on the marginal rate.
Both of these quotes are assuming that the income or IRA withdrawal occurs within a single tax bracket or does not cross some threshold for a deduction. If the income or IRA withdrawal covers multiple tax brackets or crosses a deduction threshold, one needs to calculate the effective or average tax rate.
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Re: Trying to understand the 1040 Tax Table

Post by kaneohe »

rkhusky wrote:
The Wizard wrote:That money taken from your IRA will be taxed at your marginal rate.
dickenjb wrote:Effective tax rate, while interesting, is useless for decision making. All decisions to recognize additional income or accelerate deductions are based on the marginal rate.
Both of these quotes are assuming that the income or IRA withdrawal occurs within a single tax bracket or does not cross some threshold for a deduction. If the income or IRA withdrawal covers multiple tax brackets or crosses a deduction threshold, one needs to calculate the effective or average tax rate.
or perhaps, if the additional income is occurring on top of an established base of income, it is the marginal effective rate or the effective marginal rate for that extra lump of income,
not the average tax rate of all the income but just the incremental additional income?
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Re: Trying to understand the 1040 Tax Table

Post by rkhusky »

kaneohe wrote: or perhaps, if the additional income is occurring on top of an established base of income, it is the marginal effective rate or the effective marginal rate for that extra lump of income,
not the average tax rate of all the income but just the incremental additional income?
Right. (To my ear, the latter sounds better)
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Re: Trying to understand the 1040 Tax Table

Post by Bob's not my name »

Effective tax rate has no meaning or value. It is merely a red herring that politicians of all stripes use to deceive the voting public. All financial decisions are based on marginal rate. If you have zero income, your marginal rate on a first bloc of income is less than or equal to 0%, and you make decisions on whether to realize, defer, or forgo that income based on that rate. At 0% or less, you would pick realize. At high rates you would pick defer. At very high rates you would pick forgo, the threshold depending on what work is involved in earning the income. At marginal rates greater than or equal to 100% you would forgo the income regardless of the work involved. Often you can't defer or forgo as a direct decision with comprehensive and immediate effect, but at very high marginal rates you are likely to make longer term changes that effectively defer or forgo income.

Your marginal rate must take all federal and state tax effects into account. The ever-growing list of tax effects unrelated to taxable income makes nominal bracket increasingly meaningless. Most taxpayers are subject to state income taxes or AGI-based, wage-based, or investment income-based federal income taxes, or all of them.
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Re: Trying to understand the 1040 Tax Table

Post by rkhusky »

Bob's not my name wrote:Effective tax rate has no meaning or value. It is merely a red herring that politicians of all stripes use to deceive the voting public. All financial decisions are based on marginal rate.
Incorrect. With no other income besides a withdrawal from a tax-deferred account, the effective tax rate is much more important than the marginal rate when considering whether one should have used a Roth vs. Traditional account.

As a specific example, consider a couple that has a $1M tax-deferred account. The entire account was contributed under a marginal rate of 25%. They will retire at 60 and will not take SS until age 70. They have no pension or other income. The plan is to take $100K from the account each year for 10 years to live on and any excess will be converted to a Roth. They have itemized deductions of $19,699, leaving their taxable income at $72,501 (a contrived example using the 2013 tax forms for illustrative purposes) and hence a marginal rate of 25%. Their tax is $9989 and hence an effective rate of 10%. I argue that the effective rate of 10% is the important number when considering whether the original funds should have been contributed under a traditional account vs a Roth. The marginal rate of 25%, which affects $1 of income, has no bearing on the decision. Reducing taxable income by $10 and making the marginal rate 15% would have very little impact.

The important comparison when considering Roth vs. Traditional is the effective tax rate on the contributions vs. the effective tax rate on withdrawals.
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