In the United States, the amount of tax you owe depends on several factors, one of them being how much money you make each year.
The U.S. Tax Code is based on a progressive tax system. Essentially, this means everyone pays a percentage of their income to the federal government, but higher-income people pay a higher percentage than those with less income. In theory, this system distributes the tax burden more heavily onto those who have more and thus are more able to contribute. Likewise, it shifts the burden away from those who can’t afford as much.
Over time, tax deductions, credits, and loopholes have modified and complicated our tax laws. However, the basics aren’t overly complex. The U.S. income tax system uses a relatively simple series of “stepped” tax rates to determine how much you owe.
How Much You’re Taxed
Your total tax owed is based on your adjusted gross income (AGI). When you complete your Form 1040 and its attached schedules, you enter all of your income from various categories, such as wages, interest and dividends, and business income. Then, you take various above-the-line deductions, such as contributing to an IRA or paying student loan interest. These deductions reduce your gross income to arrive at your AGI.
Your AGI is used to determine your eligibility for certain tax breaks, but it’s not your taxable income. From AGI, you deduct either the standard deduction or itemized deductions to arrive at your taxable income.
How Much You Owe
After you figure out your taxable income, you can determine how much you owe by using the tax tables included in the Form 1040 Instructions. Though these tables look complicated at first glance, they’re actually quite straightforward. You simply look up your income, find the column with your filing status (single, married filing jointly, married filing separately, or head of household), and the intersection of those two figures is your tax.
For simplicity’s sake, the tax tables list income in $50 chunks. The tables only go up to $99,999, so if your income is $100,000 or higher, you must use a separate worksheet (found on page 79 of the 2018 Form 1040 Instructions) to calculate your tax.
To illustrate, let’s say your taxable income (Line 10 on Form 1040) is $41,049. Using the tables, you’d go to the 41,000 section and find the row applicable to incomes between $41,000 and $41,050. Then, you can easily find the tax you owe:
- $4,965 if you file as single
- $4,542 if you’re married filing jointly
- $4,965 if you’re married filing separately
- $4,651 if you file as head of household
Tax tables show the total amount of tax you owe, but how does the IRS come up with the numbers in those tables? Perhaps the most important thing to know about the progressive tax system is that all of your income may not be taxed at the same rate.
2018 Tax Brackets
Tax brackets for the 2018 tax year (returns filed in 2019) are as follows:
|Rate||Single, Taxable Income Over||Married Filing Jointly, Taxable Income Over||Head of Household, Taxable Income Over|
For most people, the first dollar they earn in a year is taxed at a lower rate than the last dollar they earn. Think of it this way: Picture seven buckets representing the seven tax brackets. You’re a single taxpayer, and as you start earning money at the beginning of the year, your income starts filling the first bucket, representing the 10% tax bracket.
Once your income reaches $9,525 (the beginning of the 12% bracket), your income spills over into the 12% bucket. Once you get to $38,700, it spills over into the 22% tax bracket bucket, and so on.
At tax time, all of the money in the first bucket is taxed at 10%, money in the second bucket is taxed at 12%, and money in the third bucket is taxed at 22%. If you have more than $500,000 in income for 2018, your income will have spilled into all seven buckets, but only the money sitting in the last bucket is taxed at the highest tax rate of 37%.
Using the brackets above, you can calculate the tax for a single person with a taxable income of $41,049:
- The first $9,525 is taxed at 10% = $952.50
- The next $29,175 is taxed at 12% = $3,501.00
- The last $2,349 is taxed at 22% = $516.78
In this example, the total tax comes to $4,970.28. You’ll note that this is not quite the $4,965 the tax tables told you you’d owe. The numbers don’t always add up perfectly. However, what’s in the tax tables is what the IRS legally determines you owe, and that trumps figures arrived at from any detailed calculations you might do.
Marginal Tax Brackets
The highest tax bracket that applies to you is called your marginal tax bracket. It’s the one bracket that you cross into but don’t make it out of by the end of the year. Since you don’t hit the maximum in this bracket, this is the percentage you should keep your eye on. It’s the rate at which you’re taxed for any additional ordinary income you bring in throughout the year.
Let’s consider an example. Say you’re a single taxpayer earning a salary of $50,000. You have no pre-tax withdrawals, such as a 401(k), or above-the-line adjustments to reduce your adjusted gross income, so you claim the standard deduction rather than itemize. Your taxable income would be $38,000 ($50,000 minus the standard deduction of $12,000). That’s the 12% tax bracket, but it’s only $700 away from the 22% tax bracket.
Now, let’s say you earned $200 of interest income from your savings, received a bonus of $500 from your regular job, and earned $1,000 from a side business. That’s $1,700 in additional income for the year. Of that, $700 would be taxed at 12% and the remaining $1,000 would be taxed at 22%.
Simply put, the more money you make, the less of it (as a percentage) you get to keep if that additional income pushes you into a higher tax bracket.
How to Stay in a Lower Tax Bracket
You can reduce your tax bill with tax deductions and tax credits. Another way to reduce your taxable income, and thus stay in a lower tax bracket, is with pre-tax deductions.
A pre-tax deduction is money your employer deducts from your wages before withholding money for income and payroll taxes. Some common deductions are:
- Contributions to a 401(k) plan
- Health insurance premiums
- Contributions to a Health Savings Account (HSA) (we recommend opening a free HSA account with Lively)
- Contributions to a Flexible Spending Account (FSA)
Returning to the example above, let’s say you decide to participate in your employer’s 401(k) plan and contribute $1,500 per year to your account. Now, your taxable income is $38,200: $50,000 salary – $1,500 401(k) contribution + $1,700 in other income – $12,000 standard deduction. You remain in the 12% tax bracket while saving for retirement. It’s a win-win.
For 2018, you can contribute up to $18,500 to a 401(k) plan. In 2019, the contribution limit increases to $19,000.
If you’re self-employed or don’t have access to a 401(k) plan at work, you can still reduce your taxable income while saving for retirement by contributing to a Traditional IRA or SEP-IRA through a broker or robo-advisor like Betterment. These contributions reduce your AGI because they are above-the-line deductions (reported as Adjustments to Income on Schedule 1 attached to Form 1040). For 2018, you can contribute up to $5,500 to a Traditional IRA ($6,500 if you’re age 50 or older). In 2019, the contribution limit increases to $6,000 ($7,000 if you’re age 50 or older).
SEP-IRAs allow self-employed people and small business owners to put away much more. For 2018, you can contribute up to 20% of your net income, up to a maximum of $55,000. In 2019, that maximum increases to $56,000.
Most people watch chunks of each paycheck disappear toward their tax liability throughout the year with little understanding of how much they may owe when all is said and done. Then, during tax season, they wait for an accountant or tax preparation software to announce whether they’ll receive a refund or owe money to the IRS.
With a little understanding of the tax brackets, you can take the drama out of tax time, no complex mathematics required. This knowledge may even help you make smarter decisions about saving and investing.
Do you know your marginal tax rate? Does having that information help you make better financial decisions and plan for tax time each year?