Over that past number of weeks as we have been talking about year-end tax planning for businesses and individuals (go to our website hawkinsash.cpa or search “Tax insights” wherever you get your podcasts). We have been talking about how it looks like tax rates will be going up. As many small businesses report their business income on their personal returns, these increases in tax rates may affect them, so I just want to make sure we are all on the same page as to how tax brackets work.
Talking to some people, I think they are confused.
- I agree since this is an area that has a lot of misconceptions.
- I hear people say that they do not want to make more because it will push them into a higher tax bracket
- Although that may be true, not all their income is taxed at the higher bracket.
- Only the portion of their income in the bracket gets taxed at that rate.
What are the brackets?
- They range from 10% to 37%.
- We have a progressive tax system which means that tax rates increase as your income increases.
- Under our system of tax brackets everyone in the lower brackets get taxed the exact same way.
- Some taxpayers just reach higher brackets than others which makes their average tax rate higher.
Can you give us an example?
- Let’s say a retired couple has $25,000 of income
- In this case they would be in the 12% bracket
- But here is how the math works.
- Of the $25,000, about $20,000 is taxed at only 10%, leaving the remaining $5,000 to be taxed at the 12% rate.
How about a working couple?
- Let’s say a married couple has taxable income of $90,000. They are in the 22% bracket.
- The 22% bracket is actually the third bracket on the scale of 7 tax brackets
- The first bracket is the 10% bracket and will cover the first approx. $20,000 of income
- The second bracket is the 12% bracket and will cover approx. the next $60,000 of income
- The first and second bracket calculates the tax on about $80,000 of income
- In our example that leaves only about $10,000 which is taxed at the third bracket of 22%
That makes sense so only the last $10,000 is taxed at 22%, while the rest of the income is taxed at a lower rate.
If I do my math right, even though they are in the 22% tax bracket, their average tax rate is only about 13%.
- You got it.
Be sure to talk to a tax professional if you have any questions about income tax brackets or would like further assistance.