This year, US politicians are talking about tax rates and tax brackets. Should the ultra-rich pay a 70 percent top marginal rate? Did tax rates shrink my refund check? But I want to talk about the percent of taxes that people actually pay, known as effective tax rates. Do you know your 2018 effective income tax rate? I’ll show you mine, and how to calculate yours.
Difference Between Tax Brackets and Effective Income Tax Rate
With the 2018 tax changes, personal income tax brackets range from 10 to 37 percent. The new law lowered corporate tax rates to 21 percent. But, no one pays exactly these rates (especially big companies like Amazon, which paid no corporate income tax on $110 billion in revenue).
The amount of tax you actually pay is called your effective tax rate. According to Zachs Financial, here is how you calculate your effective income tax rate:
Divide the amount of income tax you paid by your taxable income.
You can find the lines labeled Taxes Owed and Taxable Income on your federal and state tax forms. I won’t list actual line numbers here because those vary from form to form and state to state.
My 2018 Effective Income Tax Rate
Here are the 2018 income tax rates for me and my wife, filing a joint return:
- Effective federal income tax rate: 17.77 percent
- Effective California state tax rate: 4.03 percent
- Total effective income tax rate: 21.67 percent
There are a few things to note here:
- Our effective federal income tax rate is well below the lowest tax bracket of 22 percent, even though our household income ranks in the top 25 percent. That’s why we’re talking about effective tax rates and not just tax brackets.
- People good with math will immediately see that the total rate is lower than the sum of the federal and state rates. That’s because California and the feds calculate taxable income differently.
- I calculated our total effective rate by adding together the federal and state income taxes that we paid and dividing that number by the taxable income listed on our federal tax return.
So, what is your effective income tax rate?
Effective Income Tax Rates During The Last 10 Years
Our 2018 effective income tax at the federal level is the lowest I’ve seen in 10 years. For our California state incomes taxes, it’s the second-lowest in ten years. (I’ll save the debate on whether this is a good thing for another post.)
The last ten years for me have seen a lot of change. I’ve been single and then married, and I’ve lived in all three West Coast states. I also sold a rental property in part because passive income isn’t passive.
Over the decade, my household income ranged roughly between the 75th and 95th percentile (thanks to selling that rental property).
What did my effective income tax rates look like during the last ten years?
As you can see, my federal effective tax rate was fairly constant and never about 20 percent. The state rate varied more, from 1.99 percent to 8.01 percent. This is due to fluctuating income and to differing state laws. For most of 2008, I lived in Washington state where there is no income tax. For a year in 2008-9, I lived in Oregon, which does have an income tax. The rest of the time, I lived in California, which also has an income tax.
Reduce Your Taxable Income To Lower Your Effective Tax Rate
A big reason I have a reasonably low 2018 effective tax rate is that I’ve gotten more aggressive about reducing my taxable income. I’ve done this by taking full advantage of 401(k) contributions and itemized deductions.
The following chart shows how much I’ve reduced my taxable income during the last decade:
My income reduction rate bounced along during 2011-14 because I was diverting money from 401(k) contributions to pay for my MBA degree. The reduction rate was a meager 6.44% in 2015, thanks to selling my rental property.
Starting when I got married in 2016, I got more aggressive in managing our taxable income. I’m happy that this year we avoided paying taxes on 24.12% of our total income.
(I’ll also save for another post the debate about paying taxes now or later through standard or Roth retirement plans.)
People and politicians debate tax theory all day long, but it’s the fact of effective tax rates that matter. What does your effective rate look like?
Image courtesy of Flickr