How Do Income Tax Brackets Work?

by Michael on Jan 3, 2013 · 1 comment

Image of Percentages on Blocks

I’ve recently seen a number of comments that have betrayed a fundamental misunderstanding about how income tax brackets work. I thus feel compelled to offer an explanation.

I’ve actually mentioned this in passing, but I’ve decided that it’s worth of a post of its own. Yes, this is old news for many, but not for all.

In short, your tax bracket reflects your marginal income tax rate, not a rate that is applied to all of your income across the board.

Consider a married couple (filing jointly) who had $100k in income during 2012. The 10% tax bracket applies to the first $17,400 of their income. The 15% tax bracket applies to the next $53,300 (up to a total taxable income of $70,700). And the last $29,300 of their income resides in the 25% tax bracket.

Note: Here’s a rundown of the current federal income tax brackets.

Thus, even though this couple is technically in the 25% tax bracket, they’re not paying 25% in federal income taxes. Rather, they’re paying just a shade over 17% on their $100k in taxable income, as detailed below:

$17,400 x 10% = $1,740
$53,300 x 15% = $7,995
$29,300 x 25% = $7,325
Total taxes due = $17,060

Also note that I took a shortcut by working $100k in taxable income. This couple would need to have considerably more in total income (before accounting for exemptions and deductions) to wind up with $100k in taxable income.

In fact, in the simplest possible case (2 x $3800 personal exemptions + $11,900 standard deduction), they’d need an income of $119,500 to clear $100k in taxable income. In that case, their effective rate would be $17,060/$119,500 = 14.3%.

If they had dependents, itemized deductions (e.g., mortgage interest, state income taxes, and charitable contributions), and/or above-the line deductions (e.g., IRA, HSA, or 401(k) contributions), their top line would have to be even higher to wind up with $100k in taxable income, resulting in an even lower effective tax rate.

Note that I’m also ignoring the possibility of tax credits, which would directly reduce their tax liability, further reducing their effective tax rate.

The point here is that your income tax bracket really doesn’t give a clear indication of how much you’re paying in taxes. Importantly, this also means that you won’t take home less after taxes if you slip over the line into a higher tax bracket.

1 The College Investor January 3, 2013 at 8:18 pm

So many people forget that taxes are marginal. I pay the same tax rate as Oprah for my income, she only pays the high rate on the amount she makes more than me.

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