It’s been more than a month since the passage of the Tax Cuts and Jobs Act (TCJA).
While the stock market has seemingly loved this news (S&P 500 up 7.5% this MONTH), there are many people who are less than convinced how good this will be for the country.
With reports from both sides of the political spectrum claiming how positive or negative the Act will be over the short and long term, it’s tough to really know the impact and what to expect.
One report I’ve seen many times over the last month is how the TCJA disproportionately favors the wealthy.
While this may be true, one thing I’ve noticed is that many articles use raw numbers to substantiate their reports.
For example (made up numbers): “The middle class will save on average, $2,000 in taxes, while the wealthy will save $50,000.”
Now looking at the raw numbers it’s very understandable why many consider this is to be an outrage! When seen this way of course it would favor the high earners.
However, this does not tell the whole story.
Through looking at the detail and the way our current tax code is set up, whenever there are tax cuts, the high earners will nearly always get a bigger tax cut in terms of dollar value.
Let’s take a look at why.
Tax Bracket Comparison
When looking solely at the tax code changes, it would seem that most people should benefit.
Without understanding how the table works, it would seem that for single filers, everyone benefits or stays the same except for those earning between $157,501-$191,650 (25% -> 32% tax bracket) and $200,000-$416,700 (33% -> 35% tax bracket).
For married people filing jointly, it would seem that everyone benefits or stays the same except for those earning between $400,001-$416,700 (33% -> 35% tax bracket).
However, this is not the case for either scenario.
One common misconception with the US tax bracket is that people assume that whatever tax bracket you fall in, your income is fully taxed at that level.
One may assume, for example, as a single filer in 2017 if you make $50,000 (assuming no deductions) you’re taxed at 25% and thus pay $12,500 in taxes. This is not true.
As the US has a marginal tax code, you would actually pay $8,239. Here’s how the math works:
10% of $9,325 = $932.50
15% of $28,624 ($37,950 – $9,326) = $4,293.60
25% of $12,049 ($50,000 – $37,951) = $3,012.25
Total Taxes Paid = $8,239.35
It’s because of this marginal tax code, that all else equal, there are tax cuts across the board, even for those exceptions pointed out that were going into a higher tax bracket.
Keep this marginal tax system in mind as we examine the tax impacts across several income levels.
To see what the tax impacts from the TCJA are, let’s see the differences across several income levels.
For simplicity purposes, these charts assume only standard deductions/exemptions and do not factor in any other changes to the tax code (itemizing deductions, tax credits, etc) that may affect some people more than others.
As you can see, every income level will see some kind of tax cut.
Even the single taxpayer earning $250,000 will see a tax cut though their tax bracket increased from 33% to 35%.
(Side note: wow it really pays off tax-wise to be married and filing jointly!)
And it’s true! As mentioned at the beginning, those that have a higher income will also see more money from the tax cuts.
Why the 1% will nearly always get a bigger tax cut
There are two reasons for this.
Remember how I said to keep the marginal tax code in mind?
Well, due to this, the higher earners will nearly always come out with more total dollars from tax cuts.
When changing those lower tax brackets to benefit the middle class, they will also benefit the higher earners as those dollars are being taxed lower all the way up for them as well.
Even if the highest income bracket stayed at 39.6% in 2018 the Single Filer with $1M income would have tax cuts that would still be higher than the person making $50K. See below.
The second reason?
Yep. Just as having higher balances in your investment accounts lead to more investment returns from compounding interest, making more money will inevitably lead to getting more back from tax cuts.
You can see it in the original tables.
For Single Filers making $50K, the effective tax rate drops from 11.3% to 8.7%, a 2.6% decrease which leads to a $1,269 tax cut.
However, for Single Filers making $1M, the effective tax rate drops from 34.8% to 33.1%, a 1.7% decrease which leads to a $16,451 tax cut.
See the difference?
Even with a lower percentage drop, the higher earners will still take home more money from the tax cut simply because there is more money to work with.
Essentially, yes, the high earners are getting a bigger tax cut, dollar wise, than lower earners and the middle class.
But as noted throughout the post, it’s not nearly as simple as that.
The middle class, in some cases, may be getting a higher percentage tax cut, but that will not translate to dollars due to the lower amount of taxes they were paying in the first place.
So, TCJA: good or bad?
We may not know the answer to that for many years.
In the meantime, if you’re fortunate enough to have a tax cut coming your way over the next few years, I would suggest you take advantage and maximize your investments.
As lower taxes could be considered a “raise” to your paycheck, see my post on what to do with your raise/bonus if you need help deciding where to put the extra money!
Please note I am not a tax expert. This post was meant to merely show the effects of the tax changes at a very high level. I plan to keep this blog apolitical so please keep the comment section on topic and friendly 🙂