In high school, you learned things about algebra, chemistry, and the feminist underpinnings of Madame Bovary. But you didn’t learn much about tax brackets.
So when someone asks, “How do tax brackets work?” your first instinct might be to say, “I don’t care.” If you’ve gotten by this long, why do you need to know about them now? You pay your share and don’t want to think about how tax brackets work beyond that.
Financial literacy is critical because if you don’t understand the basics of your taxes, you won’t understand what it means when Congress does things like pass a new tax bill, which they did in late 2017.
Read on to find out more about the U.S. tax brackets.
Federal Tax Bracket Fundamentals
The federal government uses seven current tax brackets for individuals. In most states, you still have to pay state income taxes after you pay the feds unless you’re lucky enough to live in one of the states without an income tax.
It’s also important to note that personal income taxes aren’t the only part of the story. You could not pay a personal income tax but still have to pay high property taxes, for instance.
Then there are sales taxes. For instance, Oregon is one of five states with no sales tax, but residents of the Beaver State still have to pay an income tax that’s one of the highest in the country.
While it’s nice to get a low tax bill from Uncle Sam, or even to get a refund, it’s only one piece of a complicated financial puzzle.
How you file also makes a difference. A single person will pay taxes differently than a married couple that files together.
Marginal Tax Rates
Most people don’t pay one single tax rate. Some of their income is taxed in the first bracket, some in the second, and so on. The lowest bracket is 10 percent, while the highest is 37 percent.
The more you make, the more you pay. That’s called a progressive system of taxing because the thinking goes that the government is taking more from those who have more to spare.
Let’s look at a progressive tax example. If you’re a single person making more than $500,000 annually, you’re looking at paying a 37 percent marginal tax rate on any income beyond $500,001.
Does that mean rich people are going to necessarily pay that 37 percent? Not if they can hire an accountant to find loopholes that will get them out of it, and generally speaking, there are a lot of loopholes in the U.S. tax code.
Some states also tax their residents progressively, while others levy a flat tax. A flat tax doesn’t change regardless of how much money you’re making.
The marginal tax rate refers to the highest tax bracket that applies to your particular level of income. Middle-class people will top out in the second, third, or maybe fourth bracket.
Unless you’re only making enough money for the lowest tax bracket, your marginal tax rate won’t be the same as your effective tax rate.
Effective Tax Rates
The effective tax rate measures how much of your overall income you pay back to the federal government. It requires some math skills to look at the current tax brackets, then figure out how much of your income applies to each bracket, and finally come up with an overall percentage you’re paying.
For the sake of simplicity, let’s take a hypothetical taxpayer named Frank and pretend they pay taxes in three brackets: 10 percent, 12 percent, and 22 percent.
Frank is single, and for single people, the 22 percent tax bracket has an income range minimum of $38,701 and a maximum of $82,500. Let’s say Frank has an overall income of $45,000.
The 10 percent bracket applies to the first $9,525 he makes, so that’s a tax bill of $952.50 for that bracket alone.
The 12 percent bracket has an income range of $9,526 to $38,700. That means hypothetical Frank will have to pay 12 percent for everything over $9,525. In our example, that means he has to pay $3,501 for this portion of his earnings.
Still with us? So far, we’ve got a tax bill of $4,453.50 as we head into the third bracket.
Since our guy’s taxable income amounts to $45,000, this is the bracket that applies to the smallest portion of his income. His tax bill here is a modest $1,386, for a total of $5,839.
Now we take $5,839 and divide it by $45,000 to get the effective tax rate. In this example, Frank’s effective tax rate comes out to 13 percent.
It’s tempting just to take all three tax brackets together, average them, and declare that the effective tax rate. However, that’s not how it works unless you can slot exactly one-third of your income into each bracket.
How Do Tax Brackets Work with Deductions?
We mentioned deductions earlier, but it’s worth revisiting. Why? For one thing, the 2017 tax bill was nearly 200 pages, and it made some big changes to the way deductions work.
Some changes are good. If you’ve got minor children, then starting this year you can deduct $2,000 for your child tax credit. That’s double what it was in 2017.
But as of 2018, you can deduct a maximum of $10,000 for state, local, and property taxes. That may be fine for people living in low-cost areas, but if you live in a state like New York or California, then that’s going to hurt your bottom line.
The loss of such deductions may explain why polls show the public isn’t in love with the tax reform bill. As of summer 2018, more Americans disapproved of it than approved of it, and it seems to be getting less popular with time.
Making Tax Brackets Work for You
By now, you should be able to answer the question better, “How do tax brackets work?” But if you still don’t have all the answers, that’s OK.
Taxes can be overwhelming regardless of if your income is $20,000 or $200,000.
The pressure is even more intense if you make a mistake and end up owing back taxes. In that case, you may feel like you’ve ruined your life.
You haven’t. Tax relief is available, and you can read our blog to find out more.