How do tax brackets work?
What tax bracket are you in? What is your effective tax rate? How much more will you pay in taxes if your income goes up? These are crucial questions to informed financial decisions. Yet, the answers can be complex, partly because the tax rate percentage progressively increases as you make more money. Even though almost everyone has heard of a tax bracket, there is considerable confusion about how they apply. Here is a primer on how tax brackets actually work and how you can best use them to your advantage.
For Federal purposes income is taxed using a series of progressive percentages of 10%, 12%, 22% 24%, 32%, 35% and 37%. Each percentage is applied across an income range, often referred to as a bracket. Here are the income tax brackets for 2023:
The percentages are used progressively and apply to the income in that bracket. For example, if a married couple has taxable income of $200,000, the brackets would be applied in sequence. The first $22,000 would be taxed at a rate of 10%, then the next $67,450 of income, up to $89,450 would be taxed at 12% and the next 101,300, up to $190,750, would be taxed at 22% and finally, only the last $9,250, up to $200,000 would be taxed at 24%. The following chart may be a helpful visual.
Note that this couple is in the 24% tax bracket, but only the last $9,250 of income is taxed at that rate. The 24% rate does not go back to the first dollar, it only applies to the last bracket. The average rate is 17%, which is a blend of the 10%, 12%, 22% and 24% brackets.
To see how best to use the brackets, let’s extend the example. If this retired couple goes back to work, earning an additional $50,000 per year, making the total taxable income $250,000, what would be the tax rate on the additional income, 17% or 24%? The answer is 24% since they have already filled the lower brackets and are now in the 24% bracket. If you are considering going back to work, it can be very helpful to look at the brackets to understand how much tax you will pay.
Conversely, if this retired couple would like to make a charitable donation of $50,000 (assuming that they will receive the full deduction and reduce their taxable income by $50,000), what would be the savings on the charitable deduction, 17% or 24%? The answer is 22.1%, which is a blend of the 24% and 22% brackets. Similarly, it is helpful when giving to understand how much it could potentially save on taxes.
Brackets are important because effective use of the brackets can be a powerful tax planning tool. Often, this involves shifting income from one year to another to make best use of the brackets. 401k plans, and Deferred compensation plans are great examples of this strategy. For example, a taxpayer in the 35% bracket can defer income through these types of plans, and pay taxes later in retirement, when income is expected to be lower.
While tax brackets can be complex, knowing where you stand can help you make informed decisions. If you need help, or want to learn more, please feel free to give us a call.