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How Do Tax Brackets Work?

Key Takeaways

  • One of the biggest misconceptions about taxes in the U.S. is how the federal income tax system works and what rate one pays.
  • The U.S. federal income tax is a progressive, graduated rate system, where rates increase as earnings increase.
    • This system features seven tax brackets—or ranges of income—that are taxed at rates from 10 percent to 37 percent.
  • The marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by the total income earned.
    • A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax.
  • The tax rate associated with your top tax bracket does not apply to all your income, just the portion that falls into that highest bracket.
    • Any income within the range of the first bracket is taxed only at that rate.
    • The next dollar you earn over the first bracket falls into the second bracket and only those additional dollars within the range of that bracket face that rate.
    • This continues until you reach your top bracket.
  • Understanding how tax brackets work can inform decisions about performing extra work through a second job or overtime, or pursuing new streams of income.

Transcript

Pop quiz: do you know what tax bracket you’re in? If you answered, “it depends,” you’re right, because parts of your income are probably taxed at different rates.

Say you have $50,000 in taxable income. Today, that dollar amount lands within the 22 percent bracket. But that doesn’t mean you pay that rate on the full $50,000.

Let’s explain.

In the U.S., your federal income tax is calculated through a progressive graduated rate system. Basically, if you make more, you’re taxed more.

Right now, we have seven tax brackets. Each bracket covers a range of taxable income, and the rate for each bracket gets progressively higher.

Any income within the range of the first bracket is taxed at that rate. The next dollar you earn over the first bracket falls into the second bracket, and only those additional dollars within that range are taxed at the new rate.

This continues as your taxable income increases.

So, in our $50,000 example, this much gets taxed at 10 percent, only this much gets taxed at 12% percent, and only this much gets taxed at 22 percent.

As you can see, whatever your top tax rate is, it doesn’t apply to all of your taxable income – just the portion that falls into your highest bracket.

When we understand how brackets work, we can better understand the tax impact of picking up a second job, putting in overtime, or any other ways we might increase our income.

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