Your Tax Bracket vs Effective Tax Rate

News about presidential nominee Mitt Romney enjoying an effective tax rate of 13.9% and billionaire investor Warren Buffett paying a lower tax rate than his secretary, often leads to outcries of a broken tax system.  But did you know that your effective tax rate may be even lower?

If you take a look at your Form 1040 from 2013, you will notice that your total income is subject to many reductions before it is taxed. All forms of taxable income are listed on lines 1-22. If some of this income is in the form of capital gains, it will be subject to a lower tax rate than ordinary income. That means from line 23 on, you can enjoy a series of subtractions to income.  There are adjustments to income on lines 23-35, itemized or standard deductions (Schedule A) and exemptions as well as tax credits.

This is why there is a big difference between your tax bracket and your effective tax rate. Let’s say your gross income is $150,000. This would imply a 28% tax bracket (depending upon filing status). However, there are many subtractions to income before arriving at the number upon which income tax is based. For example, under adjustments to income, you may have subtractions for self-employed health insurance, contributions to a Health Savings Account, educator expenses, student loan interest, and contributions to a retirement plan, to name a few. Let’s say your adjustments total $30,000. This number is subtracted from total income resulting in Adjusted Gross Income (AGI) of $120,000.

Line 40 found on page two of Form 1040 is a subtraction for the standard deduction ($6,100, $8,950 or $12,200 depending upon filing status) or if applicable, itemized deductions which are listed on Schedule A. These include some medical (note limitations), state income taxes paid, vehicle registration fees, property taxes, mortgage interest, charitable contributions, employee business expenses, to name a few. Electing to itemize is beneficial if the total of itemized deductions exceed the standard deduction for your filing status. The total of your itemized deductions is subtracted from your AGI.  If your income is above a certain threshold, part of your itemized deductions will be phased out.

For purposes of this example, let’s say that itemized deductions total $25,000. Income has been reduced by a total of $55,000, down to $95,000 but we’re still not done. On Line 42, you are allowed a deduction for exemptions. There are two types of exemptions: personal exemptions and dependent exemptions. A personal exemption is a $3,900 reduction to income. You may take one exemption for yourself and if you are filing jointly, you are allowed another $3,900 exemption for your spouse.

You may also take exemptions of $3,900 for each dependent you claim as well. A dependent is either your child or a relative or another (such as a live-in significant other) that meets certain tests. Don’t claim your spouse as a dependent. For the dependent to qualify, you must list his/her Social Security number and the number of months the dependent lived in your home. If your income is above a certain limit, exemptions will be phased out. Check out the rules for dependency exemptions in Publication 501. For this example, you have four exemptions (spouse and two children) for a total of $15,600.

After subtracting exemptions you arrive at taxable income of $79,400 ($150,000 total income -$30,000 adjustments -$25,000 itemized deductions - $15,600 exemptions)/ Tax on this amount is $11,708. To determine your effective tax rate, divide the tax by your total income: $11,708 ÷ 150,000 = 7.8%.

If you qualified for any tax credits, you may take a further reduction to your tax liability. So let’s say you installed solar panels for a total cost of $25,000. This allows a 30% tax credit or $7,500. A tax credit is applied to the tax itself; it is not a reduction to income. Subtracting the tax credit from the tax liability gives a remainder of $4,208 for an effective tax rate of 2.8%.

Take a close look at your Form 1040. By studying the line items under adjustments to income and itemized deductions, you may be able to determine what steps to take to reduce your tax liability. Ask your tax pro for a planning session to see how much you can reduce your effective tax rate.