We’re in a rare position right now in America: in the middle of a presidential race with tax day right around the corner.
That means there’s a lot of talk about taxes – who’s paying, who’s not, and how it’s going to change once one of the contenders gets elected.
This affects you pretty heavily because it has big implications about how much you’ll pay in taxes in the coming years. Your tax bracket might change. But will you even notice? You won’t if you don’t know what your tax bracket is right now.
Some people think that figuring out their tax bracket is as simple as knowing what percentage of their income they pay to Uncle Sam, but there’s a little more to it than that. Here’s how to determine your tax bracket, what you’ll pay, and – most importantly – how you can lower that cost.
What are tax brackets?
For tax brackets to make sense, you have to know a little about how the U.S. tax system works.
In America, we have a progressive tax system. Basically, if you make more money, you pay a higher percentage back to the government. This is different than, say, a flat tax system, where everyone pays (for example) 10% back to the government; people who make more will still be paying more, because 10% of $100,000 is more than 10% of $20,000, but the percentage is the same.
But a progressive tax is different. Your taxable income is divided into different income levels – tax brackets – that are taxed at different rates. These are marginal tax rates because they only apply to a portion of your total income.
This chart from Bloomberg BNA shows the different tax brackets for a single filer and the rates at which they’re taxed for 2016:
Only the amount of income that falls into a particular tax bracket is taxed that that marginal rate. That means anything below $9,275 is taxed at 10%, but anything between $9,276 and $37,650 is taxed at 15%, income between $37,651 and $91,150 is taxed at 25%, and so on.
Your tax bracket will change depending on how you choose to file: single, which you’d choose if you’re single (pretty self-explanatory); married filing jointly, if you and your spouse are filing together; married filing separately, if you and your spouse are filing individual returns; or head of household, which you can claim if you’re unmarried but paying for more than half of household costs and have a dependent.
How tax brackets affect your taxes
This can all get a little confusing, so an example is the best way to help clear things up.
Let’s say you make $65,000 a year. That puts your tax rate at 25%, so you’ll pay $16,250 in taxes, right?
Not quite – because remember, the tax rates are marginal. You’re in the 25% tax bracket, but that’s not how much you’ll pay – it’s how much you’ll pay for the highest portion of your income.
Instead, you need to calculate the tax rate for the different levels of taxable income. Using the table above, you’ll see that your first $9,275 is taxed at a marginal rate of 10%, so you pay $927.50 on that amount.
The next tax bracket cuts off at $37,650; you’ll pay 15% on $28,375 ($37,650 minus the $9,275 that falls into the previous bracket), or $4,256.25.
Your $65,000 income then bumps you up to the 25% tax bracket. $65,000 minus the previous $37,650, taxed at a rate of 25%, is $6,837.50.
Add all of those taxes up – $927.50 + $4,256.25 + $6,837.50 – leaves your total tax bill at $12,021.25.
If you take that as a percentage of your total taxable income, you’ll see that, even though you’re in the 25% tax bracket, you’re only paying 18.49% (and saving nearly $4,000 in the process).
How to lower your tax bill
It’s important to have an idea of what tax bracket you fall into so you know how your income will be affected. If you’re making $37,000 and take on a side gig that gets you another $2,000, that bumps you up into the next tax bracket.
Keep in mind that you’ll only pay the increased marginal rate on the income amount that falls into the higher tax bracket, but you still won’t be netting that full $2,000 so you’ll have to decide if that side gig is worth your time.
Of course, it also works the other way: reduce your taxable income and you might drop into a lower bracket.
There are a few ways to lower how much income you’ll get taxed on. You can claim deductions, like business expenses or mortgage interest payments; you can make donations to charity; or you can contribute to retirement accounts, like traditional 401(k)s or IRAs, that take out money from your paycheck pre-tax so you only get taxed on the amount that’s leftover.
You’ll probably only drop to a lower tax bracket if you’re right on the edge of one (or if you donate a lot to charity), but no matter what, every dollar that you don’t pay in tax means a little more money in your pocket at the end of the year.