Understanding your tax bracket can make a big difference when managing your finances. But few people really understand how tax brackets work.
Here is the easy guide to understanding tax brackets and how it impacts your personal finances.
What Is A Tax Bracket?
The United States uses a progressive federal tax system. That means that tax rates start lower then go up as income increases. Because of the way this is set up, it creates “brackets” – or ranges of income that fall within a certain tax rate.
Let’s look at the 2020 tax brackets for married joint filers to use as an example. The explanation will be the same, but the rates different, if you are filing single or as head of household.
2020 Married Filing Jointly Tax Brackets
| BRACKET | TAX IS THIS AMOUNT PLUS THIS PERCENTAGE … | … OF THE AMOUNT OVER |
|---|---|---|
| $0 to $19,750 | $0 plus 10% | $0 |
| $19,751 to $80,250 | $1,975 plus 12% | $19,750 |
| $80,251 to $171,050 | $9,235 plus 22% | $80,250 |
| $171,051 to $326,600 | $29,211 plus 24% | $171,050 |
| $326,601 to $414,700 | $66,543 plus 32% | $326,600 |
| $414,701 to $622,050 | $94,735 plus 35% | $414,700 |
| above $622,050 | $167,307.50 plus 37% | $622,050 |
What does all that mean for you?
Tax Bracket Example For An Average Income
According to the Bureau of Labor Statistics, the median US full-time wage is $47,788 (3rd quarter 2019 data).
To make this easier to understand, let’s use $47,500 per married person as an example. That’s $95,000 of household income which would be taxed at the rates in the chart above.
Based on the chart we see that your household will fall into the second tax bracket of 22% with this income level. So if you were asked, you would say you are “in the 22% tax bracket”.
Many people think in that case that they’ll owe a straight 22% of their income toward taxes. That works out to $20,900. That’s not the correct amount though!
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Here’s how much will be owed…
- The first $19,750 will be taxed at 10%, which is $1,975.
- The amount from $19,751-$80,250 ($60,500) is taxed at 12%, which is $7,260.
- The remainder above $80,250 ($14,750) is taxed at 22%, which is $3,245.
The total federal income taxes for your household at this income level will be $12,480.
This is what is meant by a progressive tax system. Different “brackets” of your money are taxed at different rates.
NOTE: The chart makes it easier to calculate your taxes. Rather than having to break up the income, it does that for you. The chart shows you the total taxes due when adding up the lower tax brackets. For example, the third bracket starts with $9,235 – because that’s the total tax from maxing out the two brackets below it. That’s why the third bracket shows that amount PLUS 22% of the amount left within that range.
Your Effective Tax Rate
When you know your total taxes due, you can divide that by your total income to calculate your effective tax rate.
In this example, your total taxes of $12,480 divided by your household income of $95,000 equals 13.1%. That’s the percentage of federal taxes owed on this example.
In a progressive tax system, your effective tax rate will always be lower than your tax bracket rate.
Your Marginal Tax Rate
As mentioned above, the sample household income of $95,000 would be in the 22% tax bracket. That’s because the income falls within the lower and upper bounds of that bracket. That bracket rate is also known as your marginal tax rate.
The marginal tax rate is the percent of taxes that will be paid on the next dollar of earned income.
Since a progressive tax system has increasing rates, your marginal tax rate is always higher than your effective tax rate.
Why You Should Care About Your Tax Brackets
There is more to this than just an exercise in math. Understanding this really can have a big impact on planning how to handle your personal finances.
I understand the need for taxes. I don’t even mind paying my fair share of taxes. But I don’t want to pay any more taxes than legally owed. If I’m feeling generous beyond that I’ll donate money to a valuable cause of my choosing.
My goal then is to keep my effective tax rate as low as legally possible.
This should be your goal too.
That’s why understanding your marginal tax rate is important.
The example family will pay 22% on each additional dollar earned – until they hit the next higher bracket. The next $1,000 will only net you $780 after taxes.
Consider this: The most recent $1,000 earned was also taxed at that rate. It only brought in $780 for you after taxes. Lowering your taxable income by $1,000 would save $220 in taxes.
How?
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How To Lower Your Taxable Income
There are a number of ways to lower your taxable income level, including:
- Taking the standard deduction. That would lower your taxable income by $24,800 for a married couple filing jointly in 2020. Elderly and blind people can claim an additional $1,300 standard deduction, so don’t miss out on that if you qualify.
- Itemizing deductions. If you can “itemize” to a total higher than the standard deduction, go this route to save money. Four of the more popular itemized deductions in 202 are:
- State and local taxes
- Mortgage interest
- Donations and gifts to charities
- Medical and dental costs above 10% of your income
- Contribute to a retirement plan. Money put into an IRA, 401k, HSA, or other qualified savings plan can usually be subtracted from your taxable income. “Usually” because some of these have limits and income phase-outs.
- Deduct business expenses. If you operate your own business you can deduct certain expenses from your taxes. A financial planner specializing in business owners and entrepreneurs can help you navigate this and other important topics.
What Do You Think?
Does that help explain how tax brackets work? Do you have any further questions about the above? How about tips you want to share on further lowering your taxable income? Let us know in the comments below.
A well thought out basic explanation. I might recommend touching on tax credits versus deductions a bit.
Good point FTF, thanks for sharing that tip. I’ll either do an edit soon or maybe write up a separate short post to cover that topic for people. Thanks!
Great Post Karla!! You have elaborately mentioned everything about tax bracket. Is there any additional standard deduction for elderly or blind taxpayers?
Hi Sophie – thanks for reading and commenting! Yes, the additional deduction for elderly and blind has been increased to $1,550 for 2017. Not sure yet what that might be for 2018. Sounds like congress might release more details as soon as today.
Brad, As I’m sure you know, the winds of tax reform are sweeping through Washington DC. From what I’m hearing, seems like those of us who live in high tax states and endure high property taxes are going to be footing more of the bill. Hoping that a higher standard deduction will compensate somewhat. Tom
Yeah, we’ll need to wait and see how that all shakes out. PVF has a nice summary write-up of the proposals so far (subject to change!) and also created a spreadsheet to help people understand how it might impact them. For us personally it looks to be a wash.
This is a great explanation of how tax brackets work. So many people are confused about it, but can really benefit from the knowledge! It really can make a big difference in your choices by understanding what that next dollar will be taxed at or how much that extra deduction will save you.
Thanks Kathryn! Good to hear that a CPA like yourself thinks it’s a good explanation! :)
So many people don’t understand tax brackets it’s frightening.
Yeah. A common misunderstanding is that if you are in a 15% (or whatever) tax bracket, that’s how much of your income you pay in taxes. More people need to understand marginal vs effective tax rates. Hopefully this post helps! :)