How Do Tax Brackets Work?

Are you getting ready to file your taxes? If so, you might find yourself needing a slight refresher on how tax brackets work. The US tax system is based on a progressive rate structure – the more income you make, the higher tax rate you pay.

But contrary to popular belief, you do NOT pay the same tax rate on all of your income. Instead, your tax bracket tells you exactly how much tax you will owe on income falling within the limits for that tax bracket. Any income below the threshold for that bracket will be taxed at a lower rate. Confused? Read on.

Finding your Tax Bracket

Federal tax brackets are based on income and filing status. Each taxpayer belongs to the 10%,  15%, 25%, 28%, 33% or 35% tax bracket. There is a minimum and maximum income for each bracket, as shown in the table below (all numbers refer to 2012 tax rates).

To find your tax bracket, first locate your filing status across the top of the table (you can check your filing status if you’re not sure). Once you have located your filing status, locate your income in the appropriate column. Look to the far left to find your tax bracket. So, for instance, if you are married, filing taxes jointly with your spouse and have a combined income of $100,000, you will fall into the 25% tax bracket. If you are single and have an income of $100,000, you will fall into the 28% tax bracket. This is referred to as your marginal tax rate.

Calculating Taxes

Once you have located your tax bracket, you can calculate your initial tax liability. You do not apply your tax rate to all of your income. Instead, you apply the appropriate rate for income in each bracket. So let’s say the married couple making $100,000 wants to see what they might owe in 2012.

1. Calculate 10% of income up to $17,400. The couple makes more than $17,400, so calculated 10% of the full amount ($1,740)
2. Calculate 15% of income between $17,401 and $70,700. Once again, the couple makes more than the maximum amount so calculates the entire potential tax. In this case, you have to subtract first: $70,700-$17,401 is $53,299. Then apply the 15% rate to get roughly $7,995.
3. Calculate 25% of income between and $70,701 and $142,700. In this case, the couple makes $100,000 and does not need to calculate the potential tax on the full income covered by the 25% bracket. Instead, calculate $100,000 – $70,701 to get $29,2999. Then multiply by 25% to get $7325.
4. Finally, add up all of the results from steps 1 -3. $1,740 + $7,995 +$7,325 = $17,060.

The couple could owe the IRS as much as $17,060 on their $100,000 in income. Note that even though they are in the 25% tax bracket they do not owe 25% of their income – instead they owe a maximum of 17%.

However, with deductions, exemptions and credits, their actual owed tax will likely end up being much less. To project your own tax liability (and potential refund), you can use our tax calculator.

Using Tax Brackets to Your Advantage

You can use the tax bracket thresholds to do a little tax planning. For instance, the couple above was making $100,000. In order to pay less than 25% on every single dollar of income, they would have to reduce income by nearly $30,000 – which is possible if they are taking full advantage of maxing out their 401ks.

At the same time, they can make $42,000 more and pay the same rate on their last dollar of income as they are paying now. Only once they hit $142,702 in income will they start paying 28% on their last dollar of income. So if they think they might bump up against the higher bracket in 2013 but have the chance to shift rental, investment, freelance (1099) or other income into 2012, they should do so. If they were making $141,000 in 2012 and thought they would make less in 2013 they might want to shift income out of 2012 to avoid paying the higher rate. If they made just over $142,700 they might want to make some extra payments to incur deductions and thus remain in the lower bracket.

You can use tax brackets to your advantage in other situations. For instance, if you know you are in a lower tax bracket this year than you will be in years to come, it’s a great time to consider a total or partial Roth IRA conversion. If you already converted and found yourself in a lower bracket than expected this year, you could reverse the conversion and then reconvert. You could also use your current and projected future tax brackets to help you decide when to harvest investment losses – take as much loss as possible (an amount equal to capital gains + $3,000) in years when you fall into a higher bracket.

Do you understand how tax brackets work? How do you use them to your advantage in tax planning? Tell us in the comments!

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