Understanding Tax Income Brackets

Mon Apr 27 2020

There’s a pretty big misconception when it comes to taxes: that making a little more money is a bad thing if it bumps you into a new tax bracket. This is a fundamental misunderstanding of how federal taxes – and tax brackets – work.

Given that the average American pays approximately $10,500 in personal taxes every year – or 14 percent of the average income in a household – it makes sense that folks might be concerned about an increase in taxes. But because the US tax system operates on marginal tax brackets, you only pay more on the income above the new tax bracket’s threshold. Let’s break it down.

What Is a Marginal Tax Bracket?

Marginal tax brackets are how federal taxes are broken down to help equalize the amount every person pays in taxes.

The marginal tax bracket is the percentage rate applied to your income in each of the tax brackets you meet. That might sound very technical, but all it really means is that if you jump from a 22 percent to a 24 percent tax bracket, only the amount above the income threshold is taxed at the new bracket.

Here’s an example. In 2020, you need to make $85,525.01 to be in the 24 percent tax bracket. Assume you are single and make $82,000 during the year before you get a $5,000 raise. The raise isn’t going to tax all of your income at the new 24 percent rate.

Only the amount over $85,525 is taxed at 24 percent. In this case, that’s $1,475: $82,000 + $5,000 - $85,525 = $1,475.

Essentially, only the additional dollars of income over the tax bracket’s threshold is taxed at the new rate.

How to Calculate Your Effective Tax Rate

In the example above, saying that you are in the 24 percent tax income bracket is true but still not completely representative of how much you pay Uncle Sam in taxes. What you really pay is called an “effective tax rate” – a number that is a true indicator of the percentage of your income you pay in taxes.

To calculate your effective tax rate:

Effective Tax Rate = Total Tax / Taxable Income

We looked at how only a portion of your total post-raise income would be taxed at 24 percent, but remember that not all of your pre-raise income was taxed at 22 percent (the tax bracket just below). Once you hit the 24 percent tax bracket, you now have money being taxed at the 10 percent, 12 percent, 22 percent, and 24 percent thresholds.

Here’s how your tax breakdown would look:

Tax Rate Total Income within Each Bracket Taxes Paid
1o% $9,875 $987.50
12% $30,250 $3,630
22% $45,400 $9,988
24% $1,475 $354
TOTAL $87,000 $14,959.50

Instead of 24 percent, your effective tax rate is $14,959.50 / $87,000 = .1719 or 17.19 percent.

The Current Tax Brackets

The threshold in each bracket typically goes up each year to account for inflation and standard wage rises. The two charts bellow illustrate the changes in the tax tables from 2019 to 2020. If you are working on your 2019 federal tax return, the first chart for 2019 will help you understand where your income is in relation to the tax bracket thresholds. The 2020 tax table is to help you budget your tax liabilities for the current tax year.

IRS 2019 Tax Income Brackets
Rate Singles Head of Household Married Filed Jointly Married Filed Separately
10% $9,700 $13,850 $19,400 $9,700
12% $39,475 $52,850 $78,950 $39,475
22% $84,200 $84,200 $168,400 $84,200
24% $160,725 $160,725 $321,450 $160,725
32% $204,100 $204,100 $408,200 $204,100
35% $510,300 $510,300 $612,350 $510,300
37% >$510,300 >$510,300 >$612,350 >$510,300
IRS 2020 Tax Income Brackets
Rate Singles Head of Household Married Filed Jointly Married Filed Separately
10% $9,875 $14,100 $19,750 $9,875
12% $40,125 $53,700 $80,250 $40,125
22% $85,525 $85,500 $171,050 $85,525
24% $163,300 $163,300 $326,600 $163,300
32% $207,350 $207,350 $414,700 $207,350
35% $518,400 $518,400 $622,050 $518,400
37% >$518,400 >$518,400 >$622,050 >$518,400

Source: Intuit

Deductions and Your Tax Bracket

Deductions reduce your taxable income. These are normally deducted from the gross income to help reduce the amount you pay in the highest tax bracket. In some cases, deductions can help bring you down to a lower tax bracket if you were just above the threshold because they are a dollar-for-dollar reduction of income.

Assume you have a $1,500 tax deduction for mortgage points paid when you closed escrow. Your income is now reduced by that exact amount. A deduction often helps those in higher tax brackets more than those in lower ones.

Here’s how the math works: the tax savings for someone in a 32 percent tax bracket on $1,500 means you reduce your income by $1,500 and save $480 in taxes. The same deduction for someone in a 12 percent tax bracket is only $180.

Keep in mind that the dollar-for-dollar deduction can be a huge help to reduce your tax bracket and therefore reduce what you owe in taxes. Remember the example of the person making $82,000 getting a $5,000 raise and being bumped into a higher tax bracket by $1,475? That $1,500 deduction brings that same person back down to the 22 percent tax bracket and eliminates that $354 in the 24 percent tax income bracket.

This is why keeping excellent records of all deductions is helpful. The most common tax deductions include:

  • Mortgage points: The prepaid interest on your home loan to help reduce your overall monthly costs.
  • Charitable contributions: Donations made in cash or items to IRS 501(c)(3) organizations.
  • Medical and dental expenses: Costs totaling over 7.5 percent of your adjusted gross income paid for medical and dental care.
  • Property taxes: Amount paid to local assessor or property tax division.
  • Work-related education expenses: Tuition, books, lab fees, and some transportation costs can be deducted when they help you improve or maintain employment skills.
  • State, local, and sales taxes: Amount paid to state and local municipalities as well as the sales tax on large purchases such as cars, appliances, and materials for home improvement.
  • Personal casualty losses: Victims of natural disasters such as hurricanes may be eligible to claim the loss as a tax deduction.

Taxes are complicated. It’s important to review your personal situation with a tax advisor to make sure you are maximizing all deductions and other tax credits you may be eligible for.

Start Saving on Your Home Insurance