Tax practitioners are often asked what will happen with regard to changes in tax law in 2013. Rather than try to predict what will happen, a concrete example of how tax brackets apply to ordinary income may be more appropriate.
The brackets provide for a progressive system of taxation, where a rate is applied to a particular range of values. If we are in the 35% bracket, we do not pay 35% on all our income. For example, assume that a married couple shows a taxable income of $100,000. The following examples apply to federal income tax only, and do not take into account amounts paid for capital gains, self-employment tax, sales or state tax.
Under the current system, (the Bush-era tax cuts) the first $17,900 is taxed at 10%, or $1,790. The second bracket taxes income between $17,900 and $72,500 at 15%, or $8,190 (72,500-17,900 x .15). The third bracket includes income between $72,500 and $146,400, taxed at 25%. Since the couple in our example only has $100,000 in taxable income, the tax is $6,875 ($100,000-72,500 x .25). The total amount of tax due is $16,855.
Assume the same facts but under the assumption that all Bush tax cuts expire. The 10% bracket is eliminated and the first $60,500 would be taxed at 15%, or $9,075. The second bracket bases tax between $60,550 and $146,400 or $11,046 (100,000 and 60,550 x .28) in tax. Notice the 25% rate is done away with, and applicable range has been increased. Total tax paid under this scenario is $20,121. The increase in tax between the two scenarios is $3,266.
All of these rates and ranges for income tax are subject to change, and we currently have a deadlock between republicans and democrats that is hindering a final decision on just how much tax individuals will pay. We will continue to monitor developments and keep our clients informed as to what will happen with respect to these and other developments.