Confused about tax brackets? In this video, Paul Sydlansky, CFP®, provides a clear, simple explanation of how our progressive tax system works and why understanding the nuances is critical for financial planning.

Topics Discussed:

• Marginal vs. effective tax rates
• Impact of filing status on taxes
• Progressive tax system basics
• Importance of tax planning

Transcript:

Hi everybody, it’s Paul Sydlansky, and welcome to episode 19 of The Build, our 24-part planning series where we take you through the life of a plan with Lake Road Advisors.

Today we’re going to talk about taxes, an extremely important part of any solid financial plan. What we’re going to do, though, since there’s so many different areas to talk to, we’re going to lay the groundwork and provide you just a basic understanding of how our tax system works, and we’re going to talk about the difference between marginal and effective tax rates.

Our system is a progressive tax system, which basically means that the more you make, the more you pay. And now understanding the nuances and the differences of our tax system is critical when building a plan. Take a look at this slide from our friends at VisiWealth, and you can see the tax brackets in the top left-hand corner.

Column one is a single filer, and the second column is a person who is married filing jointly. Both groups start out in the 10% tax bracket. However, you can see the single filer only goes up to $10,275 where the married filing jointly filer has doubled that. So what that means for a single filer, the first $10,275 of income is taxed at a 10% rate. Now, the next dollar after that $10,275 is now taxed at the 12% rate, and that 12% rate holds steady up until $41,775. So you can see here that the more you make, the higher your marginal tax rate is.

Now looking down at the bottom here, you can see something called effective tax rate. The effective tax rate is the total blended rate. This is the rate that you get by taking the total tax you pay and dividing it by your taxable income.

If you look at the four examples below, you can see the first one, a single filer who makes $150,000 in income has taxable income of $137,050. This individual, she’s paying an effective rate of 19.5% and a marginal rate of 24%. Now, over in the second column, you have somebody who’s making $150,000. However, they’re filing married, filing jointly. Their taxable income is lower because they have greater deductions. With a married couple or a married filing jointly, generally, you’re going to have two standard deductions. In this case, this individual has lower tax liability and has an effective tax rate of 14.94% or about almost 5% lower than the single filer. So you can see how being married in this case and making the same level of income means you’re paying really a lot less in taxes.

Going to the right, you can see two more examples of taxable income of $300,000. These two individuals are, one is in the marginal 35% rate, and on the far right is in the 24% marginal tax rate and the $300,000 earner – the single filer – is an effective tax rate of almost 26%, where the married filing jointly filer is about 20%.

So again, understanding these differences is critical when planning for your taxes. Now that you understand the differences between marginal and effective rate, next time we’re going to show you how to best decide whether to invest in a traditional 401k or a Roth 401k, and which one makes the most sense for you. Thanks for your time and we look forward to seeing you in our next episode.

Lake Road Advisors, a Fee-Only, independent financial planning firm with offices in Corning, NY, Ithaca, NY, and Vancouver, WA, works with clients virtually all across the country. Paul Sydlansky, the founder of Lake Road Advisors LLC, has worked in the financial services industry for 20+ years. Prior to founding Lake Road Advisors, Paul worked at Morgan Stanley in Manhattan for 13 years. While at Morgan Stanley, Paul was a senior-level manager within the Institutional Equities Department. In 2018 he was named to Investopedia’s Top 100 Financial Advisors list. Paul received a Bachelor’s degree in Economics from Marist College and holds an MBA from New York University Leonard N. Stern School of Business. Paul is a CERTIFIED FINANCIAL PLANNER™ and a member of the National Association of Personal Financial Advisors (NAPFA) and the XY Planning Network. They can be reached by phone at the Corning, NY office at (607) 438-2914, Ithaca, NY office at (607) 463-8400, or Vancouver, WA office at (607) 292-2172 or at the firm’s website at https://lakeroadadvisors.com/