Explaining personal finance can be pretty dull. That’s a problem, if you need to learn personal finance
On a plane from St. Louis to Seattle, I decided to try and fix the problem. What if I could wrap some personal finance concepts inside of a quirky (funny?) short story? My goal here is to present some information, and then add another step in the story. So, when you get to the end, you’ve been reminded of an personal finance concept- but you’ve received the information in a light-hearted way.
This blog post explain income tax rates, the effective tax rate you may pay, and the impact of limiting tax deductions.
Anyway, that’s the goal here. The stories are written in chapter order, so that there is a logical flow for the reader. Enjoy!
53 miles an hour!
Dan hit the brakes as the gripped the steering wheel- it didn’t seem like he was going the fast…is the speedometer broken?
As he pulled over to check, he saw the problem and laughed. His Honda Civic had two knobs, and they were right next to each other. One he had just used to change the clock for daylight savings time. The second knob changed the speedometer from miles to kilometers.
Get free sample chapters on my book: How To Save, Invest and Manage Debt.
He was going 53 kilometers an hour…he’d adjusted the wrong knob.
Taking a deep breath, he called Beth back and told her what had happened.
“Yeah- I panicked, ‘cause I thought I was going 53 miles an hour in a 30 zone! Anyway, tell me what Joe told you about the taxes.”
Beth shuffled through her papers. “This proposed tax cut is more complicated than I thought. I emailed you an example that Joe gave me- pull over and take a look.”
Dan pulled into a parking lot and glanced at the first line of the document:
- $120,000 total gross income, 28% marginal tax rate, 21% effective tax rate
“So, our $120,000 gross income puts us in the 28% bracket, but the tax calculation taxes some of our income at 10%, 15%… 28% is simply the top bracket.” Beth paused. “What’s important, according to Joe, is our effective tax rate, or the taxes we pay divided by our income. Last year, that was 21%, and he got that number by taking our $25,200 tax liability divided by the $120,000 income.”
Dan jotted down notes on a pad of paper. “OK- so we paid 21% of our income in taxes, and that 21% was the average of several different tax brackets…I get it.” He set down the notepad. “So, what’s the deal with cutting tax rates and also reducing deductions?”
“Check out the next few lines of the document- Joe gives us a scenario.”
- Cut in marginal tax rate reduces effective tax rate to 19%. Effective tax rate declines 2% (21% to 19%), or a savings of $2,400.
- Elimination of state tax deduction: ($120,000) X (7% state tax rate) = $8,400. The $8,400 now taxable on federal tax return.
- Tax increase/ state tax deduction removed: ($8,400 X 19%) = $1,596 tax increase
“Now, there’s a lot of moving parts, but Joe’s point is that you have to pay attention to both a cut in tax rates and the removal of deductions.” Beth shook her head. “In his example, we save $2,400 when they cut the tax rates, but we pay almost $1,600 more in taxes when the deductions are removed.”
Dan started the car. “Well, I guess we’ll have to wait and see…we can’t spend a big refund before we know the details.”
As always, check with a CPA and a financial advisor for specific answers- this is for information purposes only.
Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies
(website and blog) http://www.accountingaccidentally.com/
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Image: Maciej Lewandowski, Vintage Cars, (CC By SA-2.0)