2025 and Your Tax Rate — it’s not one rate
The ‘don’t blame me’ blurb: I am not a financial advisor, portfolio manager, or accountant. This is not tax or investment advice; it’s information to get you going. Please consult your trusty professional and do your due diligence. Carry-on!
Updated Jan 22, 2025
How personal tax rates work - it’s not one rate
It’s often misunderstood how the states and feds tax us. A misconception is that once someone hits a certain income, all of their hard-earned money gets taxed at a higher rate. This is not the case.
The taxman taxes different chunks of your income at different rates. Think of tax brackets like steps on a staircase. Each step on the stairs represents a different tax bracket, which is the percentage at which you are taxed.
The crucial thing to remember is that not all your income gets taxed at the same rate. Instead, it's taxed progressively, meaning that as you make more money, only the income within a certain bracket gets taxed at that bracket's rate.
This is called your marginal tax rate. Have a look at the tax rate table and graph below.
Let’s say you earn $110,000 in a year. You only pay the 24% rate on your earnings starting from $103,350. You only pay the highest rate of 24% on $6,650 of your income.
Table by ‘freak in the sheets’ Lacy Kilraine. By that I mean spreadsheets, as in Excel.
So what’s your overall tax rate?
This is known as your effective tax rate. It is the average tax rate you have paid on your income when you add all the tax from each bracket.
How does contributing to your i401k lower your taxes?
Contributing money to your pre-tax deferred i401k helps you avoid the highest tax brackets. Your contribution is a tax deduction.
By contributing money into the i401k, you are slicing away the top of the cake before the taxman can get at it. Take a look at the section on the i401k here if you haven’t started one.
In the $110,000 income example, putting $20,000 into your i401k results in your taxable income becoming $90,000. So now:
You’re not getting taxed on the $6,650 that was in the 24% bracket. A saving of $1,596 in tax.
The remaining $13,350 that went in to the i401k avoids the 22% tax rate. This saves you $2,937 in tax.
When you withdraw it in 20-30 years
The entire $20,000 is invested in the i401k until you start withdrawing it in retirement. It can sit in the account and grow at 7-8% annually, untouched by the tax man.
You do pay tax on it in 20-30 years when you begin to withdraw it.
Most likely, you will pay yourself less in retirement than you’re earning now, so you will pay less tax as your income in retirement will be in the lower tax brackets.
A huge advantage is that the entire amount you contributed will be able to grow every year untaxed. $20,000 growing for 25 years at 8% is $136,970. Now, think about contributing $20,000 every year for 25 years. You will have $1.6 million. Let that one sink in. $1.6 million that you had to do nothing to earn except a few mouse clicks and a little discipline.
Read the post here on how much you can spend from those funds every year in chill-tirement.
Have a play with the compound interest calculator below. Try changing the amounts and years. Set the rate to interest rate to 7% then try 8%. That’s what our Three-Fund Portfolio should make over the long term.
Terms to stick in the memory bank
Marginal Tax Rate: The tax rate you pay on the last and highest part of your income
Effective Tax Rate: The average tax rate you pay on your entire income.
The i401k is your get-rich slow tool for life as a freelancer or single-person business. Read the guide. Start that sucker now!