How Do Income Tax Brackets Work?
The United States operates a progressive tax system. This means that a person’s tax is determined by their income level. Depending on your income, you might get taxed in one or several brackets. This method makes it so that an individual with a higher income gets taxed accordingly.
Each tax year, the federal government determines taxation through the different tax brackets. They’ll usually adjust it to line up with inflation. It can get confusing, which is why you’ll need to learn everything from the basics. Here’s what you need to know:
The Basic Structure of Income Tax Brackets
To understand the basic structure of the way the government uses tax brackets, we have to look at an example. Let’s say you’re earning a wage of less than $10,000 annually. That salary makes you fall in line with the lowest income tax bracket for a single filer. You only get a 10% tax rate for that income.
Say you get promoted the following year and double your salary. The rate you now hit is the second tax bracket at 12%. Your entire income doesn’t get taxed at 12%. Instead, the initial $10,275 gets taxed at 10%, while the remainder is 12% because of the tax bracket. The same applies as you reach higher brackets. Someone with $100,000 in income will be in the 24% tax bracket, but not all of their income gets taxed at that level.
Currently, there are seven tax brackets set by the federal government, ranging from 10% to 37%. There are also slight differences for single filers, married, widowed, separate, and head of household.
It’s not just your salary that gets taxed by the government, either. They also look into investment income or profits realized from your investments. Some deductions can lower the taxes you get during that year, which will be discussed later.
The progressive tax system provides a way for people of lower income to get adjusted taxes. It’s a far contrast from a flat structure in other countries where everyone has the same tax rate. Higher-income individuals will pay more taxes because they have more income. On the other end, lower-income people will save more. The only issue with this setup is that it makes it harder to plan savings and wealth building when tax can suddenly change when you reach a new bracket.
Ultimately, you get a tax bracket, but it doesn’t necessarily tell the story of how taxation applies. To better understand that, you have to look at your effective tax rate.
Understanding Your Effective Tax Rate
The effective tax rate refers to the average tax of your income after calculations from several tax bracket levels. While it may seem that you’re getting taxed higher, the progressive system lowers the overall taxes. You’ll be able to determine this by computing the effective tax rate. For individuals, the formula is as follows:
Effective Tax Rate = Total Tax divided by Taxable Income
Let’s look at an example. Let’s say a single filer is earning $100,000 income for the 2022 to 2023 tax year. Based on the different brackets, the money will have a progressive tax like this:
The first $10,275 at 10%
The next $31,500 at 12% ($10,276 to $41,775 level)
The next $47,299 at 22% ($41,776 to $89,075 level)
The remaining $10,924 at 24% ($89,076 to $170,050 level)
That means they’ll pay a total of $17,835.04 in taxes. Using the effective tax rate calculation, we divide their total tax by their taxable income. $17,835.04 divided by $100,000 means their ERT is at 17.835%. You’ll notice that as you go higher in income, the ERT also increases slightly. It may seem glaring when you see 24% or 37% taxation, but the progressive system helps lighten the tax burden.
ERT is different from the marginal tax rate, which only accounts for the highest bracket you achieve. The ERT is a more accurate representation of your total tax liability. Because of this system, one can feel the difference in taxation when considering income levels. Even though you are in the same tax bracket as another, you may have different ERTs because one of you has a higher income.
Deductions will also play into this as they can lower your taxable income and can even push you to a lower bracket. They play a big part in how your taxes will look when deadlines are near.
With that said, tax planning is essential because it allows you to strategize your income in such a way that it doesn’t hit high tax rates. It is a kind of system where the wealthy must find different strategies to help mitigate taxes and preserve their wealth.
Current Tax Brackets
As mentioned earlier, the federal government has implemented seven tax brackets. Each filing category has a range of income that falls into one of these brackets. The seven are:
10 percent
12 percent
22 percent
24 percent
32 percent
35 percent
37 percent
There are four major categories of filers classified within these tax brackets. The numbers for a single filer will be significantly lower than a married couple because of the status considerations. These categories are
Single filers
Married couples
Married couples with separate filings
Head of household
To better understand how each category is distributed into the tax brackets, we should look at how much is taxed for each. Let’s look at it through each category:
Single Filer
10%: $10,275 or less
12%: $10,276 to $41,775
22%: $41,776 to $89,075
24%: $89,076 to $170,050
32%: $170,051 to $215,950
35%: $215,951 to $539,900
37%: Over $539,900
Married Couple (Joint Filing)
10%: $20,550 or less
12%: $20,551 to $83,550
22%: $83,551 to $178,150
24%: $178,151 to $340,100
32%: $340,101 to $431,900
35%: $431,901 to $647,850
37%: Over $657,850
Married but Filing Separately
10%: $10,275 or less
12%: $10,276 to $41,775
22%: $41,776 to $89,075
24%: $89,076 to $170,050
32%: $170,051 to $215,950
35%: $215,951 to $323,925
37%: Over $323,925
Head of Household
10%: $14,650 or less
12%: $14,651 to $55,900
22%: $55,901 to $89,050
24%: $89,051 to $170,050
32%: $170,051 to $215,950
35%: $215,951 to $539,900
37%: Over $539,900
Deductions That Affect Your Tax Bracket
Deductions are provisions within the law that allow you to reduce your taxable income. The list of items that can be deducted is updated annually, though major changes are more occasional. The goal here is to reduce the tax you owe. Deductions can help you reach lower brackets, reducing your effective tax rates significantly.
The most recent changes to deductions happened during the creation of the Tax Cuts and Jobs Act. It allowed for several items to increase their deductible amount. However, it also removed several other categories during its implementation. Items like alimony payments and professional society dues are no longer recognized.
Each year, the government sets a standard deduction limit based on your category. The numbers in 2023 are as follows:
Single: $13,850
Married Joint Filing: $27,700
Married Filing Separately: $13,850
Head of Household: $20,800
Widowed: $27,700
There are also additional deductions for senior citizens and the blind. They can get an extra $1,500 in deductions or $1,850 for single filers and heads of households. Those who fall under both senior and blind categories can get a $2,800 to $3,500 deduction, depending on their status. The numbers recently increased to account for inflation in 2023.
There are many categories to consider when filing deductions. Applying for as many as you can will significantly lower your taxable income. Here’s a look at each of them:
Student Loan Interest
One of the deductibles applied by the government is available to students and their parents. It allows you to deduct up to $2,500 in student loan interest from your higher education loans. However, eligibility for these deductions will depend on the filer’s status and current income level. For one, they must be enrolled in an eligible institution with a loan program under the US Department of Education. The full list of requirements is on the IRS website.
Mortgage Interest
This deduction allows filers to reduce their tax based on the interest they pay for a mortgage. It applies to purchasing a home, building one, or improvements. The Tax Cuts and Jobs Act set the eligible interest deduction at $750,000. Any homes purchased before its application in 2017 will still be eligible for a $1 million maximum deduction.
Self-Employment Expenses
These are deductions provided for those categorized as self-employed. You’ll have to consider the different expenses used for your business, such as travel. All these can become a deduction you can reduce from your taxable income. Some examples include:
Premiums paid for business insurance
Rent paid for any office space
Money used for a business vehicle
Interest from a business loan
Fees for specific professional membership organizations
State and Local Taxes (SALT)
SALT is a common deduction applied for federal income. Since a taxpayer is already using their income to pay state and local taxes, these can be deducted from their federal income tax. Since 2017, the ceiling for SALT deductions is now at $10,000 and will remain the same until 2025. For joint filers, it will be $5,000 each. There is controversy with SALT because it reduces the money the federal government acquires.
Retirement Account Deductions
Contributions to retirement accounts already have taxation accounted for. For pre-tax accounts like traditional IRAs or 401ks, tax is taken before the money is placed into the account. For post-tax accounts like Roth, the tax will be considered during withdrawal, meaning it doesn’t have to be taxed. You have to declare your contributions to these accounts, so the money used there won’t be included in your current income tax rate.
One thing you should know is that there is a limit to the deductions from these accounts equal to their annual contribution limit. It is $6,500 at standard and $7,500 for those above 50 years old in 2023.
Investment and Gambling Losses
In the way that investment gains are considered for income tax, losses should also be deductibles. Any reported realized loss will be included in the deductions. For example, if you invested $1,000, and lost $500 before pocketing the money, you’ll get a similar amount of deductions in your taxable income.
Gambling is also a consideration. The money you win through gambling services gets taxed at an income tax rate. There are some professions where people can consistently win money by gambling, such as poker or fantasy sports. The opposite is also true for gambling losses. Any reported money you lose will become a deduction for you that tax year.
Health Savings Account
The health savings account acts similarly to the deductions for a retirement account. Since tax there is handled separately, you don’t need to pay income tax on the money you place in it. The max you can deduct will be the annual limit set for the account for that year.
Medical and Dental Expenses
A lot of people don’t know that they can deduct percentages of their medical and dental bills. As long as you keep your receipts, you can count them as deductible out-of-pocket expenses. You can deduct any related costs that account for more than 7.5% of your adjusted gross income. These include health insurance, treatments, diagnosis, and disease prevention.
Charitable Contributions
Any contributions up to 60% of their adjusted gross income can be tax deductible for 2023. Many engage in these contributions to save money on taxes because it’s one of the most effective ways of applying a deduction. It’s also easy to contribute to and document charity.
Conclusion: If You Need Help, Contact a Core Group Expert
Understanding how your tax bracket works helps you prepare for tax season. It also gives you an idea of how you can save money through the different provisions from the IRS. However, applying all of these to maximize your savings can be challenging. The best move you can make is to consult with a tax planning professional.
The Core Group has helped many maximize their savings and plan their taxes. The team uses the best practices available for your circumstances and tailors your taxes, making it work for you. Contact us today to learn more consultation.