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
|$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!
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.