As your income increases, what happens to tax brackets and the percentage the IRS takes?
As your income rises, you move into a higher and higher tax brackets and pay a larger percentage of your income in taxes. This system is the progressive taxation design of our U.S. tax system. Today, the tax code has seven separate tax brackets, ranging from the lowest bracket of 10% for low-income earners to the top tax bracket of 39.6% for the highest earners. The upper and lower limits of each bracket vary based on your filing status.
Simple But Ugly Truth – More Income, Higher Tax Bracket, More Taxes
The truth about these tax brackets is a very simple one – as your income goes up, the IRS takes a higher and higher percentage of each additional dollar you earn. Every extra dollar you earn is worth more, to them!
Not all of your income is taxed at the same rate. The tax rate for each income bracket is called the marginal tax rate, and it is the rate you pay on each additional dollar of taxable income.
If you are a single taxpayer with taxable income of $50,000:
- Your first $9,225 is taxed at the lowest 10% rate.
- Your next $28,225 is taxed at the next marginal rate of 15%.
- Your last $12,550 of taxable income falls into the 3rd tax bracket and taxed at 25%.
The IRS taxes this income in three separate brackets at three different marginal rates. In this example, the total tax liability is $8,293.75, or 16.6% of your $50,000 taxable income. This percentage is your average tax rate and increases as your taxable income moves into higher tax brackets.
Every additional dollar you earn above $50,000 will be taxed at the marginal rate of 25% until you reach the next tax bracket, where it increases to 28%. Unless you have deductions to offset your taxable income, your average tax rate will continue to rise as your taxable income pushes into higher brackets.
If you are self-employed and make estimated payments throughout the year, it is important to keep your certified tax professional informed of your estimated income situation throughout the year and not just at year-end. They can perform effective tax planning that may be able to minimize your marginal tax rate and avoid underpayment penalties on estimated tax payments.
The Ugly Truths Get More Complicated With More Taxable Income
Here are some other ugly truths:
- As you move into higher tax brackets, the tax code can impose limits on your itemized deductions and personal exemptions that can raise your tax liability.
- You may be subject to the Alternative Minimum Tax (AMT) at certain income levels that can increase your taxes.
- Taxes on investment income and short and long term capital gains common to high-income earners can also impact your tax liability as they are taxed at different rates than regular taxable income.
A certified tax professional provides tax-planning services to help you effectively manage and minimize the tax impact of these potential issues.
What’s The Good News About Tax Brackets?
Not everything is dire as you enter higher tax brackets. The effect of marginal tax rates in your tax brackets causes your average tax rate to rise slowly. It is not as jarring an impact as it may appear looking just at the marginal rates.
The tax code is also much more favorable to married couples filing joint returns than it is to single filers. Using the previous example, a married couple filing jointly with $50,000 of taxable income would pay $6,577.50 in federal tax or 13.2% of their income, or $1,716.25 less than a single person. That is because it takes much more income to change tax brackets as a married couple filing a joint return.
Also, exemptions for new children and itemized deductions for mortgage interest and property taxes on your home and charitable giving (just to name a few) could cause your tax liability to decline while your income increases. A certified tax professional can evaluate whether you are maximizing your itemized deductions.
Marry For Love – But Take The Tax Benefit!
Moving into a higher tax bracket also provides an incentive to save for retirement. It makes a tax-deferred savings plans (like your 401k) much more attractive, especially in your peak earning years. Amounts saved in your 401k are not taxed until you withdraw these funds in retirement when you are likely in a much lower tax bracket.
Click to contact our team at Incompass today to make an appointment for a face-to-face tax consultation, or to ask questions about your specific tax bracket. We will discuss your current tax situation and review any potential tax-saving opportunities you may be missing.