Level 2. Understanding Taxes & Tax BracketsOnline version
Click through the example to understand how the tax system works based on the different tax brackets.
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PROGRESSIVE TAX SYSTEM
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TAX BRACKET
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INCOME
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1ST BRACKET
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2ND BRACKET
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3RD BRACKET
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4TH BRACKET
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5TH BRACKET
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6TH BRACKET
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7TH BRACKET
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TOTAL TAXES PAID
Explanation
In a progressive tax system, you pay more taxes the more income you earn. (This is the tax structure for INCOME. Other taxes, like sales tax or personal property tax, use a flat or regressive tax structure, which is where everyone pays a fixed rate.) This example shows how FEDERAL taxes are taken out. Not all states use this same structure; some have a flat tax while others have no taxes at all.
This chart shows how income is divided into different brackets. Although income tax is progressive, it isn't all taxed in one bracket. It's a marginal tax system, which means that each rate only applies to the income within that range. Look at the buckets of water, for example. Your income passes through each bucket, and taxes are paid ONLY on the water that fills the bucket. The amount that spills over and fills the next bucket is taxed at that rate.
This bucket represents the total yearly income. For this example, let's say Alex earns $100,000
Income in this bracket is taxed at 10%. If you refer to the chart, you will see that the first $11,000 is taxed at this rate. The remaining $89,000 of Alex's income would pass through the next bracket.
Income in this bracket is taxed at 12%, but only up to $44,725. If you take away the portion of Alex's income that was already taxed ($11,000), this would leave $33,725 that Alex would pay 12% ($4,047) on. The remaining $55,275 of Alex's income would pass through the next bracket ($100,000 - $44,725 = $55,275).
Income in this bracket is taxed at 22%, but only up to $95,375. If you take away the portion of Alex's income that was already taxed ($44,725), this would leave $50,650 that Alex would pay 22% ($11,143) on. The remaining $4,625 of Alex's income would pass through the next bracket ($100,000 - $95,375 = $4,625).
Income in this bracket is taxed at 24%, but only up to $182,100. Since Alex earns $100,000, this is the last bracket he will be taxed at. And since $95,375 of his income has already been taxed, he only has to pay 24% on the remaining $4,625, which would be $1,110.
Alex's income does not reach the 32% tax bracket, so this would not be applicable
Alex's income does not reach the 35% tax bracket, so this would not be applicable
Alex's income does not reach the 37% tax bracket, so this would not be applicable. Only very high incomes reach this level.
To find the total taxes paid by Alex, you would add up the taxes paid in each bracket: 1st bracket = $1,100, 2nd bracket = $4.047, 3rd bracket = $11,143, 4th bracket = $1,110. Alex paid $17,400 (17.4%) in federal taxes, leaving him with $82,600. If he only paid taxes based on the tax bracket he was in, he would have paid $24,000 instead (100,000 x 24%). The marginal tax structure is designed to save taxpayers more money.
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