How To Make Sense Of Tax Brackets

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Understanding your tax bracket can make a big difference when managing your finances. Few people really understand how tax brackets work. Here is the easy guide to understanding tax brackets and how it impacts your personal finances.

Making sense of tax brackets | personal finance

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 proposed 2018 tax brackets for married joint filers to use as an example. The explanation will be the same, but the rates different, if you are single or filing as head of household. You can see the full currently proposed 2018 brackets and rates here.

Note that those 2018 brackets are very much subject to change. If tax reforms are passed this year, we’ll possibly see some extreme adjustments.

2018 Married Filing Jointly Tax Brackets (proposed)

BRACKET TAX IS THIS AMOUNT
PLUS THIS PERCENTAGE …
… OF THE
AMOUNT OVER
$0 to $19,050 $0 plus 10% $0
$19,050 to $77,400 $1,905 plus 15% $19,050
$77,400 to $156,150 $10,657.50 plus 25% $77,400
$156,150 to $237,950 $30,345 plus 28% $156,150
$237,950 to $424,950 $53,249 plus 33% $237,950
$424,950 to $480,050 $114,959 plus 35% $424,950
above $480,050 $134,244 plus 39.6% $480,050

What does all that mean for you?

Tax Bracket Example For An Average Income

According to the Bureau of Labor Statistics, the average US full-time wage is $44,148.

To make this easier to understand, let’s use $44,000 per married person as an example. That’s $88,000 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 25% with this income level. So if you were asked, you would say you are “in the 25% tax bracket”.

Many people think in that case that they’ll owe a straight 25% of their income toward taxes. That works out to $22,000. That’s not the correct amount though!


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Here’s how much will be owed…

  • The first $19,050 will be taxed at 10%, which is $1,905.
  • The amount from $19,051-$77,400 ($58,350) is taxed at 15%, which is $8,752.50.
  • The remainder above $77,400 ($10,600) is taxed at 25%, which is $2,650.

The total federal income taxes for your household at this income level will be $13,307.50.

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 $10,657.50 – because that’s the total tax from maxing out the two brackets below it. That’s why the third bracket shows that amount PLUS 25% 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 $13,307.50 divided by your household income of $88,000 equals 15.1%. 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 $88,000 would be in the 25% tax bracket. That’s because their the income falls within the lower and upper bounds of that bracket. That bracket rate is also know 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 25% on each additional dollar earned – until they hit the next higher bracket. The next $1,000 will only net you $750 after taxes.

Consider this: The most recent $1,000 earned was also taxed at that rate. It only brought in $750 for you after taxes. Lowering your taxable income by $1,000 would save $250.

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 $12,700 for a married couple filing jointly in 2017. Elderly and blind people can claim an additional $1,550 of 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. Five of the more popular itemized deductions in 2017 are:
    • State and local taxes
    • Mortgage interest
    • Donations and gifts to charities
    • Tax preparation fees (above 2% of AGI)
    • 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 (even if its a blog) you can deduct certain expenses from your taxes. Even if you don’t have your own business, if there are expenses related to work that weren’t reimbursed, you may be able to deduct those too.

What Do You Think?

Does that help explain how tax brackets work? Do you have any further questions on the above? How about tips you want to share on further lowering your taxable income? Let us know in the comments below.

 

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10 Comments

  1. FullTimeFinance November 2, 2017 at 12:01 pm - Reply

    A well thought out basic explanation. I might recommend touching on tax credits versus deductions a bit.

    • Brad Kingsley November 2, 2017 at 1:00 pm - Reply

      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!

  2. Sophei @ Basic Finance Care November 2, 2017 at 12:56 pm - Reply

    Great Post Karla!! You have elaborately mentioned everything about tax bracket. Is there any additional standard deduction for elderly or blind taxpayers?

    • Brad Kingsley November 2, 2017 at 1:00 pm - Reply

      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.

  3. Tom @ Dividends Diversify November 3, 2017 at 1:30 pm - Reply

    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

    • Brad Kingsley November 3, 2017 at 1:48 pm - Reply

      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. Here’s a link to his post, and the spreadsheet is mentioned/linked inside there. https://www.presentvaluefinance.com/gop-tax-reform-analysis/

  4. Kathryn @ Making Your Money Matter November 6, 2017 at 5:08 pm - Reply

    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.

    • Brad Kingsley November 6, 2017 at 7:11 pm - Reply

      Thanks Kathryn! Good to hear that a CPA like yourself thinks it’s a good explanation! 🙂

  5. JoeHx January 10, 2018 at 7:44 pm - Reply

    So many people don’t understand tax brackets it’s frightening.

    • Brad Kingsley January 10, 2018 at 7:46 pm - Reply

      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! 🙂

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