EPFS 025 - Understanding Tax Brackets: Debunking Common Misconceptions

understanding tax brackets and debunking some common misconceptions this week on the extreme personal finance [Music] show hey everyone my name is Chris and joining me my co-host this week is Dan my buddy Dan how you doing man hello Chris good how are you I'm doing well I'm doing well you're tuning in from uh new location yeah man yeah I'm actually uh I'm currently in Chicago so yeah I came into Chicago last night um I have a concert that I'm going to see tonight I'm pretty excited to see and uh but so a couple things happened which is interesting so I I got the this concert ticket few months back and I started looking at hotels and I'm like w why are hotels like $400 a a night like this it was just crazy I could not find a hotel in Chicago yeah didn't know the uh the DNC was happening in Chicago last night gotcha and it was yeah it was crazy but so then so yeah so there was a lot of stuff going on uh these last couple nights here in Chicago but the interesting thing is just a few weeks ago I was talking with with a friend of mine and I said yeah I'm going down to Chicago and um he just actually just said hey well if you need a place to stay you can just use my condo and I was like okay that's awesome so yeah he um he's got a condo um you know about uh you know 15 minutes from you know Union Station right that down right downtown and uh so a couple things one I I got this really nice condo I get to stay at for a few nights um also this was the first time I took the brand new uh Borealis amre line from Minneapolis to Chicago and I got to tell you it's fantastic this is the first time I've ever ritten a train oh yeah yeah and I ni it was a it was awesome I will say yeah it how long's that trip on the train yeah like like seven hours it took about seven hours or so but I will tell you you know you can work you can watch shows you can it's one I will tell you like so I left from Union Depot Downtown St Paul and I mean Dan it's so chill like it there it's so easy there there's no security you just freaking there's so much room on the train like way more room you would get on a plane and you can get up the the room is yeah you can walk around you can go from car to car you can walk to the food car and buy snacks like it was just I could see myself doing this again it it all right like I said first time and I was pleasantly surprised and also I I met people that I wouldn't have me I met this other woman too she was actually on her way to her like 50th High School reunion and it was also her first time on a train and so both of us were like little kids in it like oh my gosh look at this oh look at this like you know and uh that's awes even like even just going to um like even just using like the laboratory like the restroom like the restroom the restroom is like three times the size of those little tiny restrooms on the like anyway so it was a good experience and well and think about it too even seven hours is so that's longer than the plane ride but I think one of the things that gets I don't know why we don't count it when we think about plane trips but you have the driving to the airport say it's 40 minutes depending on where you live yep getting through security well there's another 40 minutes maybe longer depending on what's going on totally so hour and a half so far um then then you get and then you don't want to cut it too short for security right you don't want to like to security and then boom run in the plane so you get like a 30 minute buffer from getting through security and then on the plane so now you're at two hours then the plane rides an hour so you're at three waiting for everyone who stands up right away when you land to get off the plane that's the thing so you're absolutely right d i was to say boarding and deboarding or I don't even know what to call it on the plane or on the on the train yeah so getting on and getting off the train uh that was just a way easier experience too like it just I mean it's not like there were still people but it just didn't seem as crowded and you weren't doing so much standing around and it just like I said I was pleasantly surprised so again you add up all that other time um yeah and I learned too like you know Amtrak they have like a premium lounge and if you start doing regular trips like it would make sense to get premium and I just had a coach seat so if like you get like you can get like business class you can get a private car uh like a private cabin you can do all these other things too so I'm gonna start exploring that and I will say just the coach class alone it got me so I was GNA actually drive this trip and the coach class was $41 each way so it cost me 82 bucks I would not have been able to do that on a tank of gas in my truck so no so anyway it's right on sounds like a good experience I'll have to check it out I know yeah that's that's my story so yeah I'm excited to see uh again I got a heavy metal band I'm gonna see tonight named Kitty I've been a fan for them for like 20 years uh banned out of Canada I've never got to see him live so I'm super excited to check them out tonight at the Concord Music Hall Downtown Chicago so I'll a great time thanks dude D I appreciate it so you know what there's one thing Dan I want to I want to there's one thing we we have to talk about and that is you know Benjamin Franklin he has said that in this world nothing can be certain except death and taxes you know it's uh I've heard that it's inevitable right taxes are just a way of life and it you know we always hear about people a lot of people complain about taxes I mean I do too right we talk about all these taxes that we spend we but again you know I understand that there's definitely things that you know we need the roads that we drive on and the public schools we send kids to and all these things we know that there's there's there's reasons why um we need to pay our taxes but I think we need to have this discussion around just our regular income tax because it can be confusing especially if you're new right if if you're new to you know you've gotten your F your your even if if you're a kid you got your part-time job or your first big boy big girl job out of college all of a sudden it's like whoa I'm paying like who is FICA and why are they taking all my money you know like U and I just I think it's something to look at understanding what tax brackets mean because I think there are some misconceptions out there and one of the big one that I think we're going to get to is this like promotion tax penalty myth like this thing that people think they're like oh I don't want to I don't want to get the raise because well now I got to pay more taxes so and that's where I'm excited to kind of have this discussion with you today yeah for sure there's a lot of things said around the tax code and I I think it's one of those things where uh for whatever reason you know it gets made out like it's like all taxes are super complicated right and so I was actually thinking about this before we before we got on today so last week August 14th um was because every day has to have something right but it was National Financial awareness day so really I didn't know that I should have known that yeah and it's what's kind of nice is it's in August because April is financial literacy month so they don't they don't put it all in one month you know it's like we'll we'll tag it in April a little bit and then in August we'll bring it back up just so it's this constant reminder of hey don't forget to be financially literate so um and I just think one of those really important places that we could be you know aware financially aware is our taxes and and how they work and knowing I think what's important is to not get overwhelmed as soon as you hear the word taxes because that's what I think most of us do you hear taxes and you think oh this this you know 7,000 page tax code that it's got to be so hard well I mean that's for all of the possible tax situations in the United States right right and not not you or me in our own world that's not all 7,000 pages are going to apply to our situation right so just taking a a breath that right at the beginning be like taex is okay let me learn about these a little bit you don't have to learn all 7,000 pages of the tax code to understand how our income individually is is impacted so right I think that's just one one thing right off the bat to be aware of is that maybe it's not as scary as it gets made out to be and if you are in a situation where it's that scary you're probably in a situation where you're hiring somebody to take care of for you anyway yeah you know it it's inter interesting you say that um you I was having a conversation recently about about taxes and how to better prepare and kind of look at strategy and tax strategy and yeah you know if if if you do have um a more complicated situation right like multiple rental incomes different side hustle incomes different you know I have multiple llc's I have you know there's a lot of different thing you know I'm you know doing 1031 tax exchange I'm doing doing all these different weird right things that again could be more more complicated so yeah I'm uh I'm paying someone to help me organize that but that's that's that's unique case right well and odds are if you are also in that complicated attack situation um to put it gently I guess you can probably afford to have somebody help you with it you know um for people who they have their full-time job and maybe a side hustle it's probably easy enough for them to just figure it out with a little bit of encouragement to just you know take read the choose your own Venture that is the the 1040 tax form yeah and just work your way through it exactly and just not being too scared of I think I think people really can figure it out one of the common like sources or one of the common places of confusion is really understanding how X brackets truly would affect someone's income because I think people think they're like oh I fell into the 22% T tax bracket and they automatically assume that well now all their income is now taxed at that that 22% but help us understand that I mean that that's not the way it works so let's go ahead and talk break this down a little bit well first let me say this that's very common and if that's what you uh currently think and you're like wow I didn't know that it's okay I thought that until about 10 years ago right um so it's because it's not really something that is well most of us it doesn't really get taught and then even when we do try to self-educate sometimes it's still worded strangely um for instance like the us if you ask what kind of tax system does United States use people say it's a progressive tax system it's like okay what does that mean right right you know um so basically and you you chime in here too cor me if I if I say something that's that's still a little weird to understand but as um as you progress up in in income there are there there are points where brackets where each new bracket that you go into that next level of income gets taxed at that next higher percentage not all the way back down through all of the income you've recurred so far so there's actually and we can put a link to it in the show notes um there's a article about tax brackets that Fidelity put out and I'm sure Schwab and and Vanguard and any number of ones will have good ones too but I particularly like this one from Fidelity because it has this image of I love I love that image this is the first time I've seen this yeah this is the first I've seen this and you shared it's awesome it's a great example of how that Progressive system works yeah it's it's very intuitive because you seea other ones will show it like it's a a pyramid with the base tax bra down the bottom it looks like this huge tax bracket and then it works its way up to this the 37% tax bracket that's this tiny little tip of the pyramid it's like but that's a bigger number why is it just this the little pyramid at the it doesn't it's not quite intuitive but so this image and and then please everyone go go click that link down in the bottom and see it for yourself but I'll talk it through if anyone's just listen to this as they're driving or or out for a walk or whatnot um there's a picture of a faucet and the water is going down into the first tax bracket bucket which is 10% and so everything that fills up that 10% bucket gets taxed at that and then once you're over just for simple math right now we'll call it 10 grand once you're over $10,000 the water will spill over and get caught in the in the next bucket down and so all the income that spills over over into that next bucket is taxed at the 12% bracket not the money that's still back over here in this this 10% bucket and then the 12% bucket gets filled and then it spills over to the next one and so on and so forth so only the income or the water in this visual representation that is in that bucket gets taxed at that rate right so then when you add it all back up even if you're in that 24% tax bracket that doesn't mean you're paying 24% on all of your money exactly so that Progressive system is that as your income increases the percentage of tax you pay also increases but it's important to understand it's only the income within each bracket is taxed on that corresponding rate not your entire income which is important to know because you mentioned this right at at the top of the recording you know sometimes people will shy away from taking a promotion or maybe they don't want to for temporary sake of needing a little bit extra income for a little bit take on a second job because they're like oh well that will push me up into that next tax bracket to where I'm actually losing money because now all of my income is taxed more and I make less right so I don't know if that was something that that that uh you experienced at one point point in your life or whatnot so yeah when when was your uh eyes opened to that yeah again early on you know you hear um yeah no you're absolutely right Dan and I I did feel that as well I me early on it was it was hard for me to understand that that tax bracket those different buckets again it's a great illustration but also there was this this myth um typically referred to is that promotion tax penalty myth and this is something where people people may like you said not take on that that second job or not take you know they don't want to get this promotion they don't want to get a raise because they feel as though well I'm not going to be making anything I'm not gonna be making any more because I'll just be having I have to pay more taxes and again that's really not how it it it works and so the interesting thing because of the way that that progressive tax system works only the portion of your income falls into that higher bracket taxed at the higher rate the rest of your income is still taxed at the lower rate so any raise or promotion will never actually reduce your take-home pay like if you get a raise or a promotion you'll always be able to see uh some sort of pay increase now again I would start to debate the fact that well if you want to start to uh not experience um you know life creep and stuff like that maybe you want to still live below your means and maybe those raises you kind of shift to other retirement contributions or other savings accounts and that type of thing but your take-home pay will still be more if you if you get those raises it's not like you're just gonna all of a sudden pay all of your raise to taxes that's not how it works right there's no 100% tax bracket right exactly exactly so I think I mean it uh we would love to hear from the community and and from those of you out there too we kind of felt the same way early on it's important to understand how that progressive tax system works in the US understanding that your income how only those first portions fall into a t bra tax bracket anything additional falls into the next tax bracket and so on and so on want to hear from you you have any questions thoughts concerns uh about tax brackets or anything else that you want to talk about feel free to let us know we're always happy to engage with you guys ask some questions just have open dialogue and conversations you can always email us you can find our email in the show notes as well I'm going to go and put uh links in the show notes to a lot of the resources we talked about today we have a couple different posts from the IRS from Fidelity as well as heavy metal money the blog that talks about really understanding how tax brackets work and Dan I'm going to turn back to you any kind of last minute words of wisdom some thoughts on you know understanding tax brackets and what can really help those that um maybe still kind of struggling a little bit with uh with understanding that well I think if you're still really struggling with it one is so a lot of times I will revert back to focusing on the financial counseling aspect of it and a big thing with that is if you're struggling with it you're not alone other people are struggling with it too so take a little bit of comfort in that that it's not there's not something that you've done wrong there's not something that um that you're not smart enough to have figured this out so just kind of accept where you are in the moment it's like okay I'm still struggling with this so what can I do about it and know that there are any number of resources out there uh We've mentioned Fidelity anytime also feel free to email me and either I can help you directly or help you get pointed in the right direction um there's your community is going to have a lot of free tax whether it's a library or some of the um every year the the free tax help you know reach out to them as well and I want to I want to actually plug you are uh putting together a really cool tax document like a Google sheet that will help people um I know you showed that me earlier I think it's a really great tool that people can use yeah it's uh still needs a little bit of tweaking um you know I built it so it makes perfect sense to me so got to put a few things in there just with some instructions and and how to use it but it's a really good estimation tool so that you're not caught at the beginning of the next year when you're doing your taxes saying oh I still owe you know several $100 or you know maybe maybe I'm getting too much back I could have had less withholding throughout the year so um get some uh get some instructions put on there and then also just know though that it's a it's an estimation tool it's not tax advice it's not something to be used in lie of any uh professional help it's just something to kind of get you in the ballpark and have a better understanding of how it works awesome awesome I love it man and I think that you again this is just scraps in the surface right we just spent you know 20 minutes talking about it there's a lot and we didn't get any anything about some of the state taxes and there's different states that have different uh taxes we didn't talk about like you know you quickly mentioned about plan for tax withholding you know if you are an employee and understanding how to do that and we even talking through like maximizing some of your tax advantage accounts or a lot of other things that we could do we didn't even get into talking about take advantage of tax credits that are out there um other deductions that can happen this is just scratching the surface we'll have additional uh episodes where we can dig deeper into any of these topics abut I want to thank everyone for listening thank you so much Dan thank you so much buddy I appreciate it's always fun hanging out and um we will see you next time on the extreme personal finance show see you n [Music]