Do you know how much you paid in taxes in 2021? Not how much you owe or how much of a refund you’re getting. That’s different. What amount of tax did you pay on each dollar that you earned?
It surprises us every year when folks don’t know the answer to this question. Not to worry! We can easily get in the ballpark.
If the number is escaping you, maybe you know what your gross income was? Or how much you get paid each pay period?
From here we can determine what tax bracket someone falls into. Which we can then use to determine how much they actually paid in taxes. And, finally, convert that to a percentage.
But! It’s important to use the correct percentage!
How to Determine What You Actually Pay in Taxes
The tax filing deadline, April 18th, is right around the corner. Please get started working on your return if you haven’t already. And if you work with a tax preparer, now is the time to get them all relevant information.
So about that correct percentage…
One of the biggest misunderstandings we see folks make when preparing their financial plans is confusing their marginal tax bracket with their effective tax rate. This is really important because the numbers can often be far apart.
If you’ve ever been frustrated and thought, “ahh Uncle Sam gets 32% of my money” because you fall in the 32% tax bracket, we’ve got some news for you.
The United States uses what’s called a “progressive tax system”. This means the higher your taxable income, the higher your tax bracket.
BUT!
While you may fall in the 32% tax bracket based on your taxable income, that DOES NOT mean that all of your money is taxed at 32%. That 32% is known as your marginal tax rate. Your marginal tax rate is the rate that is applied to the last dollar of your earnings.
While this number usually sticks out to folks because it’s easy to remember, it sometimes does not represent the actual amount of tax you paid.
So, continuing our example of being in the 32% tax bracket, let’s say your taxable income (not gross income) was $165,000. Referring to the image above, you are $75 into the 32% tax bracket. Technically, yes, your marginal tax rate is 32%, but your ACTUAL tax rate, or EFFECTIVE tax rate, will be much lower than that.
Your effective tax rate is much more useful because it represents the actual rate at which your money is being taxed. This doesn’t take everything into account. You have to account for things like capital gains and other tax credits or deductions.
If you work with a tax preparer they should provide you with your effective rate when they give you your return. But if you are doing your return on your own, you can still calculate this number fairly easily.
Find the line on your tax return that says “this is your total tax”, take that number and divide it into your adjusted gross income.
We’re not surprised to find folks that are in the 32% marginal tax bracket with an effective tax rate of somewhere around 18-20%. It will be different for everyone.
It’s important to use your effective tax rate when planning for the future. It is the number we use when building financial plans. It helps us better estimate future tax liabilities when taking distributions from retirement accounts.
It is also useful when doing cash flow management because it better reflects how much money you are actually receiving in your paychecks. This is important because the closer you get to nailing your current year tax withholdings, the less likely you are to owe money at the end of the year.