Let’s talk tax brackets. Federal income tax brackets, to be more specific.
I suppose I am a little late for the busted college basketball bracket analogy, but this just couldn’t wait for March Madness 2020. Not to mention, there really isn’t much of an analogy back to basketball. After all, college athletes don’t get paid. Well, at least they shouldn’t. But I suppose if they did take illegal payments, the IRS would want a piece of it. Seriously, the IRS does impose taxes on illegal activities, it is spelled out right in publication 17.
“Illegal activities. Income from illegal activities, such as money from dealing illegal drugs, must be included in your income on Schedule 1 (Form 1040), line 21, or on Schedule C (Form 1040) or Schedule C-EZ (Form 1040) if from your self-employment activity.”Your Federal Income Tax (2018)
Thankfully, at least so far, I have been able to stay away from illegal income.
Here at Max Out of Pocket, a healthy knowledge of the United States tax code is going to be a prerequisite for some of the topics up on the docket. I even got a little ahead of myself earlier this year by talking about front-loading and matchmaking without fully explaining the underlying concepts. I normally try not to get myself pulled to deep into the tax weeds, but tax brackets are a fundamental concept to understand. They will be an important thing to keep an eye on as income rises or when we start comparing things to the federal poverty level for healthcare purposes.
These concepts build, so sit back, but pay attention.
Total Income vs. Taxable Income
So when we talk about tax brackets, we are talking about taxable income. Taxable income is income that is taxed after deductions. I didn’t want to litter this post with confusing sounding words like tax credits, exemptions, and deductions; we can work on those concepts later in bite-sized chunks. The takeaway here is that taxable income is not the same thing as total income. Total income lands on line 6 of the 1040 tax return where taxable income lands on line 10 of the 1040 tax return. Taxable income should come in much less than total income.
So What Is A Tax Bracket?
Simply put, a tax bracket is a taxable income range that is taxed at a certain federal income tax rate percentage. In other words, the IRS is taking a certain percentage of earned income to fund the federal government. It isn’t optional and is completely separate from Medicare FICA and Social Security FICA since those are funding specific programs. Federal income taxes are like the third pillar of income taxes. Here are the 2019 federal income tax brackets as you might commonly see them published
Here is the same information for married people.
Like many other things, Max OOP actually likes to consider these buckets, not brackets. It still fits the basketball analogy so I am allowed to do that. Believe it or not, when I started this questionable blogging career, the blog was pretty close to being called “filling up buckets”, but I thought I would get too much traffic from the personal flood community and crash my server. That domain name is still open if anyone is interested in completely copying my idea.
Just because someone lands in a certain tax bracket doesn’t mean all of their income is taxed at that rate. I wanted to specifically call that out since it is a common misconception. The following chart shows how many tax dollars each bucket can hold and the total tax should if someone was to fill up the bucket.
Here is the same information for married people.
There are seven tax buckets, and each bucket has a different tax rate assigned to it. Once you fill up your first bucket, you move onto the next one. With that new bucket, you start getting taxed at a higher rate. From above, you can see the first bucket for married people holds $19,400. The second bucket holds $59,550. The first two buckets are my favorite since they have a very favorable tax rate. I will go as far as to call them the sweet spot of early retirement and sabbatical engineering. More on that later. Here is another look at the same information:
A Game Of Basketball With My Uncle Sam
Pretend for a moment Max OOP gets paid in cash every Friday. So every Friday after work, I skip down to the IRS building to shoot hoops with my Uncle Sam and settle up my federal income taxes with him. The year is 2019. After I fill up my deduction buckets, I start dropping my earnings from the week into my first tax bucket so it can be taxed. Since Max OOP is married, my first bucket can hold 19,400 of my hard-earned dollar bills. When I put money in this first bucket, my Uncle Sam hands me 90% of it back and he keeps 10% to help maintain the basketball courts. I feel pretty good about this deal I have with my Uncle Sam. I end up with $17,460 when I am done filling up my first bucket.
Tax Bucket One = $0.00 to $19,400
$19,400 X 10% = $1940 Federal Income Tax
$19,400 – $1940 = $17,460 Take Home
But once that bucket fills up, there is no more room for my 19,401th dollar. So now when I skip down to the IRS building, the deal changes. I have to start filling up my second bucket. My second bucket is much larger and can hold 59,550 more dollar bills. But for every dollar added to this bucket, my Uncle Sam starts taking 12% instead of 10%. In other words, I get $0.90 of my 19,400th taxable dollar, but I only get $0.88 of the 19,401th taxable dollar that lands in my second bucket. If we add my first two buckets together, we are talking $78,950 in taxable income.
Bucket Two = $19,401 to $78,950
$59,550 X 12% = $7,146 Federal Income Tax
$7146 + $1940 = $9086 Federal Income Tax
Once Max OOP is pretty deep into the calendar year, I have filled up my first two buckets with a total of $78,950 and I have been taxed a total $9,086 I am usually no longer skipping down to the IRS Building at this point, it’s probably more of a brisk walk. That’s because I know the third bucket is waiting for me, and my Uncle Sam is getting sick of putting out buckets.
The third bucket is even bigger; it holds 89,450 dollar bills. But there is a price to pay to put my 78,951th taxable dollar in this bucket. This bucket has the largest jump in tax of all seven buckets. The tax skyrockets from 12% all the way up to 22%, or 22 cents on the dollar. The Max Out of Pocket crew does not even come close to filling this bucket up, so we will selfishly end the story there. Feel free to finish it for yourself if you are lucky enough to have a 4th, 5th, 6th, or even a 7th bucket. My guess is most Max OOP readers would only need to worry about three or four of the buckets. This simple example obviously ignores deductions and other fancy tricks to reduce total income.
Bucket Three = $78,951 to $168,400
Any dollar in bucket 3 gets hit with a 22 cent tax.
I actually do everything in my power to keep my dollars out of the third bucket since the tax rate has such a harsh increase (10 percentage points). I mentioned earlier this year that by maxing out my 403(b) I was deferring 22 cents on the dollar in federal income tax. This is because Mrs. Max OOP and myself will land solidly in the 22% federal tax bracket in 2019 without any deductions. So any dollar I can keep out of that tax bucket with a deduction, I defer 22 cent tax on that dollar.
Tax brackets are a really good place to start an understanding of the tax code. Max OOP found several years back that if I could keep my income out of the 22% tax bucket, I could greatly accelerate my path to early retirement while also positioning for unexpected health issues. The actual tax percentages on each bracket changed for 2018, but I don’t think we are ready for another history lesson yet. That said, the large 10% jump we see in the middle of the tax brackets has been around for some time.
We will discuss several more ways we can keep dollars out of these more expensive buckets later. I will also zero in on bucket one and two and talk more about how those buckets can be used to engineer sabbaticals, finalize early retirement out of the corporate world with confidence, and set up a completely tax-efficient last year of corporate work. I think these buckets are the sweet spot of early retirement and the Max Out of Pocket crew has proven we can put up a high-quality life at this income level.
I happen to think the tax rate is pretty reasonable for these first two buckets. But let’s not get crazy and interpret that as a political statement, it’s a simple mathematical statement. We like to try and stay apolitical here at Max Out of Pocket. When you consider all of the ‘deduction buckets’ we get to fill up before income even starts filling up the 10% Tax Bucket, you can pretty easily reduce your effective tax rate with a few small tweaks. I am not talking some corporate tax breaks no one can understand here. I’m talking about aggressively applying mainstream concepts that anyone can use if only willing to live at a reasonable standard of living. This includes your Average Joe Max. But we’ll have to save that for another day, another dollar, and another bucket.
Just a reminder I am not a tax professional, this is just a hobby. You should always review your own situation with a tax professional before making any decisions.
How did your March Madness 2019 go? My bracket was busted! At least Michigan State made it to the final four! Go Green!