We have a progressive tax rate in the United States. Basically, this means you are not taxed the same rate on all your income. The tax rate progresses (increases) as your income increases. Although complicated, this makes it a fairer and more just outcome for taxpayers, as your tax rate is dependent on the amount of income you earn. If you earn more, you pay more. But you pay more on the income in the higher tax bracket, not on all your income.
Tax professionals use words like tax bracket, tax rate, marginal tax rate, and effective tax rate. Each of these means something different, although in some cases the difference is minimal. Understanding how your tax bracket and these tax rates are determined will help you understand how the amount of tax you owe is calculated. Whether you are trying to decide to cash in your retirement account to buy that cabin you have always wanted or considering picking up a part time job, understanding how your tax bracket and tax rate determines your tax liability will help you make better financial decisions.
Understanding the lingo is key to understanding how your tax rate plays a huge part in financial decisions.
Tax Bracket. Your tax bracket is the band at which your income is taxed. Your tax bracket is determined both by your filing status and your taxable income. Because the US tax system is progressive not linear, just because your income falls within a certain tax bracket does not mean all your income is taxed at that rate. That is, your tax bracket refers to a range of income that is taxed at a given rate. The Tax Cuts and Jobs Act of 2017 authorized the IRS to use the Chained Consumer Price Index (C-CPI). This means each year the tax brackets are adjusted for inflation based on the C-CPI. The IRS, usually in the early fall, releases the updated tax brackets for the following tax year.
Tax Rate. Simply stated, your tax rate is the percentage at which your income is taxed.
Marginal Tax Rate. Your marginal tax rate is the percentage at which your additional income is taxed. Unless you are pushed into a higher tax bracket, your marginal tax rate matches the tax bracket for your last dollar of income. In other words, it matches the tax rate for the tax bracket band where your highest amount of income falls.
Effective Tax Rate. Your effective tax rate is the average amount you pay for taxes based on all your income. Although many tax professionals will provide your effective tax rate when they complete your taxes, you can calculate it simply by dividing the total amount of your tax paid by your total income earned. For example, if a family made $100,000 and paid $10,000 in federal income taxes, their federal income effective tax rate would be 10% ($10,000/$100,000).
The IRS released the tax inflation adjustments for tax year 2020. These adjustments based on the C-CPI affect your tax bracket, which determine your tax rate. For 2020, there are seven tax brackets: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Your tax bracket is based on both your filing status and the amount of income that you earn. The tax brackets for 2020 apply to income earned in 2020, which will be reported on the tax return you file next year in 2021.
For people filing as single, the tax brackets are as follows:
For people filing as married filing jointly, the tax brackets are as follows:
For people filing as married filing separately, the tax brackets are as follows:
For people filing as head of household, the tax brackets are as follows:
Keeping in mind we have a progressive income tax, which causes your tax rate to increase as your income increases. Let’s look at a couple of examples of how you can determine your tax bracket, tax rate, marginal tax rate, and effective tax rate.
Example # 1 - Filing Single / No Dependents. If John earns $45,000 in 2020 and files as single, he falls into the 22% tax bracket. This is because looking at the tax brackets for someone filing as single, John’s income is greater than $40,125 but less than $85,526.
Because the income tax is progressive, this does not mean that John is paying 22% on all his income. He is only taxed 22% on his income that is greater than $40,125 or ($45,000 - $40,125) $4,875.
John’s income would be taxed as follows:
First $9,875 at 10% ($9,875 - 0) x 10% or $987.50
Next $30,250 at 12% ($40,125 - $9,875) x 12% or $3,630
Last $4,875 at 22% ($45,000 total amount of taxable income - $40,125) x 22% or $1,072.50
Total federal income taxes paid on John’s $45,000 equals $5,690 ($987.50 + $3,630 + $1,072.50).
If John earned an additional $10,000 in 2020, it would also be taxed at 22% because he would still be making less than $85,526, which would keep him in the same tax bracket. This means of the additional $10,000 earned, 22% or $2,200 in federal income taxes would be owed. Because 22% is the amount John’s additional income would be taxed, 22% is also his marginal tax rate.
John’s effective tax rate of 12.6% is calculated by taking the amount of taxes he owes or $5,690 and dividing it by the amount of income he earned or $45,000. This means on average John only pays a little less than 13% in taxes.
Example # 2 - Filing Married Filing Jointly. Bob and Anne earn $60,000 and file their taxes together using the status married filing jointly. The tax brackets for couples are larger. This means that even though Bob and Anne earn $15,000 more in 2020 than John, they fall into the lower tax bracket of 12%.
Bob and Anne’s federal income tax would be calculated as follows:
$1,975 or ($19,750 x 10%), plus
$4,830 or ($60,000 - $19,750 already taxed) x 12%).
Bob and Anne would owe a total of $6,805 in federal income taxes on their $60,000. This means their effective tax rate would be 11.3%.
Understanding your tax bracket and tax rate is important when making financial decisions. For example, imagine if both John and Bob and Anne were thinking about purchasing that cabin they had dreamed about. But, to make it happen, they would need to make a withdrawal from their retirement account which would be taxed as ordinary income.
If John just turned 48 years old and wanted to withdraw $50,000 from his retirement account to put down as a down payment on his cabin, he would have to pay a 10% early withdrawal penalty plus 22% federal income tax on $40,525 and 24% federal income tax on $9,475. He would owe the 24% on the amount he earned greater than $85,525 because withdrawing that much would push him into the higher tax bracket of 24%.
This means withdrawing the $50,000 would cost John $8,915.50 ($40,525 x 22%) plus $2,274 ($9,475 x 24%) plus $5,000 (10% penalty x $50,000) for a total amount owed on his federal income tax return for the $50,000 of $16,189.50. Almost ⅓ of the amount he withdrew! Since John is still working, it might make more sense for him to borrow the $50,000 rather than cutting the IRS such a huge check and leave his retirement income to grow.
In the same situation, if Bob and Anne, who just turned 60 decided to withdraw $50,000 from their retirement account as a down payment on their cabin, they would only owe $8,555 in federal income tax return for the $50,000. Bob and Anne would not owe the early withdrawal penalty since they were over 59 ½ years old.
The taxes Bob and Anne would owe on the $50,000 withdrawn from their retirement account is calculated as follows:
$22,250 at 12% ($80,250 - $60,000) or $2,670; plus
$26,750 at 22% ($50,000 - $22,250 (amount taxed at 22% tax rate) or $5,885.
Similar situations, yet it would cost John $7,634.50 more in taxes to withdraw the same amount from his retirement account.
This is just one example of how your tax bracket and tax rate can affect your financial decisions. Some other examples are if you are considering withdrawing your retirement income for any reason including paying off debt like your mortgage or helping your children pay for college or their first home. It’s important to remember the tax consequences. Also, this information is useful when considering tax deductions like charitable giving.
For example, if it is December and you are considering giving a large donation to your church, take a moment to consider which tax year it will save you the most money on your taxes. If you know you are going to earn more money in 2021, which is going to push you into a higher tax bracket, it may be worth you waiting until January to write the check. However, the reverse also can be true. If you know you are going to retire and your taxable income is going to drastically reduce in 2021, you should give the money in 2020, when it will bring you the most tax savings. You also will need to consider if you qualify to take the itemized deduction rather than the standard deduction.
Do not forget to consider tax consequences when making financial decisions. Tax implications are often overlooked and can be devastating. Do not be caught by surprise come tax time when you get a huge tax bill. Speak to a tax professional before you make the financial decision, so you can plan accordingly.
With a little preparation, you will have the information you need to make a better, more informed decision. Maybe that means you wait a little longer to buy the cabin. But when you do purchase it, it will be that much sweeter knowing you saved thousands on your tax bill.
If you are considering financial decisions that have tax implications or you are not sure if they have tax implications or not, schedule an appointment today with the accounting and tax preparation professionals at Gudorf Tax Group. They will walk you through how your tax bracket and tax rate impact the financial decision you are facing.