How Tax Brackets Work

Tax BracketsWe can’t go through tax season without covering how federal income tax brackets work.  The U.S. has a progressive tax system.  While someone may be sitting in the 25% federal tax bracket, that doesn’t mean they actually pay that much in taxes.  It only means that 25% is the marginal tax rate.

The marginal tax rate represents the tax rate on the last dollar of your income earned.  It doesn’t represent the tax rate on your total taxable income.

To find the tax rate we pay on our total taxable income we need to find the average tax rate.  Which takes a bit of math.

The best way to explain it is with an example.  I’ll be using the 2012 federal tax brackets for a single person as a reference.  For our example we’ll assume this single person has a taxable income of $500,000.  Which is beyond average but I wouldn’t be able to use the entire table below that I labored over for hours.

Tax Rate Single Income Break Down Taxes on $500,000 in Taxable Income
10% $0 – $8,700 The first $8,700 10% of $8,700 or $870
15% $8,700 – $35,350 The next $26,650 $870 plus 15% of $26,650 or $4,867.50
25% $35,350 – $85,650 The next $50,300 $4,867.50 plus 25% of $50,300 or $17,442.50
28% $85,650 – $178,650 The next $93,000 $17,442.50 plus 28% of $93,000 or $43,482.50
33% $178,650 – $388,350 The next $209,700 $43,482.50 plus 33% of $209,700 or $112,683.50
35% Over $388,350 Amount over $388,350 $112,683.50 plus 35% of $111,650 totaling $151,761.00 in income tax!

As we see from the table, we are only taxed on the amount of income that falls into each tax bracket.  For that single person making $500,000, the first $8,700 will be taxed at the 10% tax rate, then the next $26,650 ($35,350 – $8,700) will be taxed at the 15% tax rate. The next $50,300 will be taxed at 25% and so on as the last column shows.  That shows us a total of $151,761 in income taxes.  We can divide that total by the taxable income ($151,761 / $500,000) to get an average tax rate of just over 30%.

For another example lets use a more realistic $35,350 in taxable income.  This person will pay 10% taxes on the first $8,700, then pay 15% on the remaining $26,650.  Which comes to $4,867.50 in taxes or an average tax rate just under 14%.  If that same person made just $1 more, moving them into the 25% tax bracket, only the $1 would be taxed at 25%.  Which amounts to 25 cents in more taxes.

So what does all this mean.  We should still try to lower our taxes as much as legally possible by maximizing credits, deductions, and contributions to retirement accounts.  So when you file your taxes, don’t be afraid of earning more money and falling into a higher marginal tax rate.

We will always pay more taxes as our income increases.  But, when our income increases, our after tax income will always increase too.

Get the most out your tax refund.  Find all the credits and deductions you are eligible for with Turbotax or H&R Block online  tax software.

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  1. says

    It’s so silly when people are like “aw man, I got a raise but now I’m in the next tax bracket.” Well, yeah you’re paying more in tax, but you’re also making more and you’re still coming out ahead.

    • J.P. says

      @Kacie and @Don – It’s understandable with the complexity of the tax system. But anyone with an income should have a basic idea of how the system works.

  2. says

    This seems so basic to me but I know so many people that don’t understand it. Having this resource to give to friends is great. They think that if you earn more you make less, but that is far from the case.

  3. R C says

    If the above calculations are correct, why does the 2012 tax table show a tax amount of $876.00 on $8,700.00, that comes to more than 10%. Wouldn’t that come to 10.065% IRS is calculating? 10% would come to the $870.00 you stated above.

    • J.P. says

      Maybe I’m confused RC, but I don’t see the $876 on the 2012 tax tables or the table above. You’re right, the calculation above is correct.

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