Understanding Tax Rates: A Money Eva Guide to Codifying Your Own Tax Calculations

Tax season is here, and understanding how tax rates work can help you make smarter financial choices. Whether you're calculating income tax, capital gains tax, or planning your next investment move, knowing the fundamentals can save you money.

In this post, we’ll break down three key concepts: marginal vs. average tax rates, capital gains tax rules, and how you can codify your own tax situation in Money Eva for your investment scenarios.

1. Marginal vs. Average Tax Rates: Understanding Tiered Income Tax

Income tax in most countries follows a tiered or progressive structure. This means different portions of your income are taxed at different rates.

• Marginal Tax Rate refers to the tax rate applied to your next dollar of income. It is determined by the highest tax bracket your income falls into.
• Average Tax Rate is the total tax paid divided by total income, giving you an overall percentage of income paid in taxes.

Example:

Imagine the following income tax brackets:

• 10% on income up to $10,000
• 20% on income between $10,001 and $50,000
• 30% on income above $50,000

If you earn $60,000:

• The first $10,000 is taxed at 10% = $1,000
• The next $40,000 ($10,001-$50,000) is taxed at 20% = $8,000
• The last $10,000 ($50,001-$60,000) is taxed at 30% = $3,000
• Total tax paid: $12,000
• Average tax rate: $12,000 / $60,000 = 20%
• Marginal tax rate: 30% (the rate applied to your next dollar earned)

Understanding these rates is crucial for making informed decisions on additional income, deductions, or retirement contributions.

Take tax-deferral strategies like contributing to a 401(k) in the U.S. or an RRSP in Canada. These contributions directly lower your taxable income for the year, reducing the amount of income that falls into higher marginal tax brackets.

For example, if you're earning $60,000 and your marginal tax rate is 30%, contributing $5,000 to a tax-deferred account lowers your taxable income to $55,000. This means you save 30% of that $5,000 in taxes today—$1,500 in immediate tax savings.

However, this isn’t tax-free money—just tax delayed. You’ll pay taxes on withdrawals in retirement, but ideally at a lower tax rate if your income is lower in retirement than it is now. This makes tax-deferral strategies a powerful tool for optimizing your marginal tax rate today while maximizing long-term savings.

2. Capital Gains Tax: Short-Term, Long-Term, and Exempt Gains

Investors and homeowners often deal with capital gains tax, which applies when you sell an asset for more than you paid for it.

A common misunderstanding is that the tax applies to the entire sales proceeds when selling an asset. In fact, taxes are only applied to the gains—the difference between the selling price and the original purchase price (cost basis), after accounting for transaction costs such as commissions or legal fees. This means if you bought an asset for $5,000, paid $100 in transaction fees, and sold it for $8,000, your taxable capital gain is not $8,000 but rather $2,900 ($8,000 - $5,000 - $100).

Understanding this distinction is crucial because it affects how much tax you truly owe and helps in planning the right time to sell investments to minimize tax liability.

Short-Term vs. Long-Term Capital Gains (US Rules)

• Short-term capital gains (assets held one year or less) are taxed at your ordinary income tax rate (same as wages).
• Long-term capital gains (assets held more than one year) are taxed at preferential rates (0%, 15%, or 20% depending on income).

Example: If you bought stock for $5,000 and sold it for $8,000:

• Short-term: If sold within a year, the $3,000 profit is taxed at your marginal income tax rate.
• Long-term: If sold after a year, the $3,000 profit is taxed at 0%, 15%, or 20%, based on your income.

Exempt Capital Gains (Canada: Principal Residence Example)

In Canada, when you sell your primary residence, you don’t pay capital gains tax thanks to the Principal Residence Exemption (PRE). However, if you sell a rental or vacation property, gains are taxable (50% inclusion rate applied to your income tax bracket).

In Canada, capital gains are taxed differently from the U.S.—instead of applying a fixed percentage to the gains, only 50% of the capital gain is included in your taxable income. This means if you have a $10,000 capital gain, only $5,000 is added to your income and taxed at your marginal rate.

Understanding capital gains tax can help you decide when to sell investments or real estate to minimize taxes.

3. Money Eva’s Approach: Codify Your Unique Tax Situations

At Money Eva, we believe tax calculations should be transparent, straightforward, an adaptable to your unique situations. Instead of relying on hardcoded tax rules, we enable you to use mathematical functions like min(), max(), and basic arithmetic (+ - * /) to compute your tax scenario effectively.

Example: Average Tax Rate Using min() and max()

To calculate 2024 U.S. Federal tax for Married Filing Jointly status:

Average Tax Rate = (
  (min(max(A, 0), 23200) - 0) * 0.1 
  + (min(max(A, 23200), 94300) - 23200) * 0.12 
  + (min(max(A, 94300), 201050) - 94300) * 0.22 
  + (min(max(A, 201050), 383900) - 201050) * 0.24
  + (min(max(A, 383900), 487450) - 383900) * 0.32 
  + (min(max(A, 487450), 731200) - 487450) * 0.35 
  + (max(A, 731200) - 731200) * 0.37
) / A

Visit our Knowledge Hub to view and contribute!

Final Thoughts

Understanding marginal vs. average tax rates, capital gains tax, and exempt gains can significantly impact your financial strategy. Everyone has unique situations, and Money Eva is here to help you take control of your finance outlook with confidence and clarity.

Ready to explore for yourself? Try Money Eva today and see how tax rates impact your financial decisions!