There’s a very simple thing most people get wrong about taxes

If you're in the 25% tax bracket, you don't pay 25% in taxes.

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If you’re in the 25% tax bracket, you don’t pay 25% in taxes.
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Thomson Reuters

  • The Republicans’ proposed tax bill would change income tax brackets in 2018.
  • But many Americans don’t understand how tax brackets work.
  • We put together a handy guide to explain.

The massive Republican tax bill passed Congress on Wednesday.

The bill, called the Tax Cuts and Jobs Act, is now heading to President Donald Trump’s desk for a signature to enact it, though it’s unclear when that will happen.

By looking at what Trump’s tax plan means for Americans’ take-home pay at different income levels, our team at Business Insider got a number of emails that made us realize something important: Most people don’t understand how tax brackets actually work.

Many people look at their tax bracket and think, “If I make $40,000 per year, then all of my income will be taxed at at 25% under current law, and at 22% under the Republicans’ proposal.” But that’s not how taxes are calculated under our progressive tax system.

tax brackets single filers final 2

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Elena Holodny/Business Insider

Here’s how the calculation does work for a single taxpayer in 2017:

  1. Figure out your taxable income: annual salary – deduction(s) – exemption(s).
  2. Everyone pays 10% federal income tax on their first $9,325 of taxable income.
  3. Everyone pays 15% federal income tax on their next $9,326 to $37,950 of taxable income.
  4. Everyone pays 25% federal income tax on their next $37,951 to $91,900 of taxable income.
  5. And so on and so forth.

Your tax bracket applies only to the amount you earn above the minimum income threshold for that bracket. For income below that limit, you pay the same federal income tax amount as everyone else, even if they earn less overall.

One notable thing about this kind of tax set up is that the amount of taxes owed by someone steadily increases as the amount of income increases. It’s not a monumental change when people jump from one tax bracket to another.

effective tax rates_1024

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Andy Kiersz/Business Insider

Let’s run through how this would work for an imaginary person, Picard, who earns $40,000. To keep it simple, let’s say he makes all his money from his work salary and has no dependents.

For his 2017 taxes (which are due April 17, 2018), Picard would subtract the standard deduction ($6,350) and one personal exemption ($4,050) from his $40,000 income.

This brings his taxable income to $29,600, putting him in the 15% tax bracket. But here’s how to use the tax brackets to calculate how much he actually owes in federal taxes:

  • The first $9,325 (of his $29,600 total taxable income) is taxed at a 10% rate.
  • Then, his income from $9,325 to $29,600 is taxed at a 15% rate.
  • So he would owe about $3,974 in taxes.

Under the GOP’s proposal, Picard would only take the $12,000 standard deduction, because personal exemptions would be eliminated. That makes his taxable income $28,000 under the GOP tax plan, putting him in the 12% tax bracket.

Here’s how to estimate how much he would owe in taxes if the Republicans’ proposed tax brackets become law:

  • The first $9,525 (of his $28,000 total taxable income) is taxed at a 10% rate.
  • Then, his income from $9,525 to $28,000 is taxed at a 12% rate.
  • So he might owe about $3,170 in taxes.

If you have any other questions about taxes in general, or about the Republican tax plan proposal, shoot us an email at yourmoney@businessinsider.com!