How Tax Brackets Work

from the Michael Atias, Online Trading Academy

Special Report from Online Trading Academy

The United States currently uses a progressive income tax system (marginal tax brackets). This means that the more money you earn, the more taxes you must pay.

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For 2018 tax year there are 7 marginal tax rates: 10%, 12%, 22%, 24%, 32%, 35% and 37%.

2018 Federal Income Tax Bracket Table

Tax Bracket Basics

The amount of taxable income that you earn determines which tax bracket(s) you fall into. Taxable income is generally described as gross income or adjusted gross income (which is minus any deductions allowed in that tax year). Under the new tax reform rules, for 2018 about 90% of taxpayers are expected to use the standard deduction ($12,000 for Single, 24000 for Married Filing Joint).

While it is the goal of many taxpayers to keep their income in the lower tax bracket, remember that the gradual tax schedule ensures that not all your income is taxed at a higher rate. For example, if you move from the 24% tax bracket to the 32% tax bracket, you may think that all your income is taxed at that higher rate. However, only the money that you earn within the 32% bracket is taxed at that rate.

Tax Bracket Calculation Example

Suppose you are:

• Single with no dependents
• Claim the standard deduction ($12,000 in 2018)
• Your Adjusted Gross Income is $100,000
• Your taxable income is $88,000 ($100K minus $12K standard deduction)
• Your federal income tax is estimated to be about $15,409.

Notice that even though your marginal tax bracket is 24%, your effective tax rate is only about 15.41%! So, your effective tax rate is basically the total tax you paid divided by your total income earned as a percentage.

The reason that your effective tax rate is substantially lower than your marginal tax rate is because your income was taxed at 4 different tax brackets:

• The first $9,525 taxed at 10% for total tax of $952
• The next $29,175 taxed at 12% for total tax of $3,501
• The next $43,800 taxed at 22% for total tax of $9,636
• The last $5,500 taxed at 24% for total tax of $1,320

This progressive tax bracket system is causing the average tax rate you are paying to be lower than the marginal rate.

Making Better Tax Decisions

Knowing your tax bracket could lead to making more informed decisions on your part. Let’s say you’re considering working overtime or adding a part-time position making an additional $1,000 in a year. If you are in the 24% bracket you will pay $240 in income tax plus 7.65% in social security and Medicare. The net amount you will receive will be about $683. This knowledge may lead you to decide that the extra job isn’t worth and you’d prefer spending that time with your friends & family, doing volunteer work or exercising more. It is possible to find other ways to generate this amount of income or savings, like restructuring your debt or lowering your insurance cost without investing more of your time at a job.

Knowing your tax rate also helps when you’re thinking about making retirement plan contributions. Contributing to a traditional 401(k) plan or traditional IRA will reduce your state and federal income tax. In turn, that makes your contribution more affordable. The higher the tax bracket you are in, the more appealing it is to make a larger contribution into a retirement account.

You can also make more calculated decisions regarding when to receive nonstandard income like unusual bonuses, stock options, sale of a property, etc. when you are aware of what tax bracket you are in. For example, if you know that receiving a bonus this year will cause you to jump from a 24% bracket to a 32%, then you may consider splitting the income into two tax years or deferring it to the following year, if possible.

For more information about tax brackets or tax consulting, reach out to a tax advisorand make sure you are minimizing your tax liability.

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