How Tax Brackets Work: With Easy to Follow Examples

How tax brackets work largely depends on how much income you earned in a given year. Determining the amount of income you earned in a given year is not necessarily hard. After all, your employer distributes a Form W-2 to you. Form W-2 outlines the gross income you made at a specific employer, as well as, the amount and type of taxes that were withheld from your check. With this form, your tax professional can transfer this information on your tax return and file it. 

The bottom line on your tax return will either be a tax refund or a tax liability. But how exactly is this determination made? What percentage of your income is subject to tax? How is it calculated?

The answers are not that simple. The facts are, tax is paid based on different tax rates for different portions of income. This is how tax brackets work.

Tax Brackets: What Are They?

To understand how tax brackets work, it’s important to know what they are. A tax bracket is an income range taxed at a certain rate. For example, the tax rate you are assessed on the first $10,000 of your income is taxed differently than on your last $10,000. Why? There’s no clear-cut answer. Many would argue a flat tax rate system would be easier. Either way, the U.S. government implements a progressive tax system. Meaning, tax rates increase as an individual’s income increases. 

With tax reform in full effect, many are asking how will their tax bill be impacted. Check our tax reform blog,  The New Tax Plan and Exactly What It Means For You, to see how common deductions and credits have changed.

Below, you can see how individual tax brackets will change. At first glance, the new tax brackets seem to favor most taxpayers. Let’s see how.

Overall rates have dropped for most taxpayers. However, not everyone benefits from the general tax cuts. For example, most of those who were once in the 33% bracket have been bumped up to the 35% bracket.

Let’s take a real-world example of how tax brackets work and how you can calculate your own. We will also be looking at the how the new tax brackets compare.

How Tax Brackets Work: Example

Let’s take Mary, a single, full-time dentist with zero dependents. After meeting with her CPA and applying all of her applicable deductions, Mary’s adjusted gross income is $168,000 in the current tax year.

As you can see from the table above, Mary falls in one tax bracket for the tax year 2017 (28%) and into another for the tax year 2018 (32%). Her income tax rate has increased! But does this mean she will pay more in taxes?

Here’s the math: 

How tax brackets work is first, you calculate your lowest bracket’s tax expense and gradually work your way up until you have reached your highest income bracket. The lowest tax bracket being the first $9,325 of income, which is taxed at 10%.

The next bracket is taxed at 15%. It’s important not to double count your income, meaning since the first $9,325 of income has already been taxed at 10%, you would deduct that amount from the higher end of the next bracket. Example: $37,950 minus $9,325, as shown above. The difference here is then multiplied by 15%.

As you move higher and higher in the tax brackets, you will have to subtract the previous bracket’s higher end number from the current bracket’s higher end number. The purpose of this is to ensure that you are not double taxing income that has already been taxed.

In our example, we work our way up to the 28% tax bracket since that’s where Mary’s $168,000 taxable income falls. The highest income in that bracket is $191,650 but since she made $168,000, we take the difference between $168,000 and the previous bracket’s higher number of $91,900. This is so Mary is not taxed on income she did not earn. 

After calculating each bracket’s tax expense, it is summated to arrive at the total year’s income tax expense. The brackets above are indicative of the 2017 tax year. With tax reform passed and ready to be implemented in the 2018 tax year, taxpayers like Mary may experience significant changes. Let’s take a look at our sample example, keeping in mind the new rates for the tax year 2018.

How tax brackets work in 2018 are the same as with all previous years. Income in certain ranges are taxed at different rates. The only thing that has changed are the actual rates.

Judging by the tax bracket rates alone, it appears that Mary would be paying more in income tax in 2018 than in 2017. She fell in the 28% tax bracket in 2017 and 32% tax bracket in 2018. Yet, somehow she ends up paying roughly $5,000 less in taxes. How? Well, it’s mostly related to where her income falls within the brackets. For the most part, all of her lower brackets had reduced from 2017. 2018 added one additional higher bracket on a small portion of her income which did not have a huge impact on her bottom line.

Tax Brackets vs. Effective Tax Rate (ETR)

One way to measure the tax impact on your income is by determining the effective tax rate. ETR is a measure of the average rate you pay at which your earned income is taxed. In our example, Mary’s 2017 effective tax rate is 23.8% ($40,021.75 / $168,000). Mary’s effective tax rate in 2018 is 21.1% ($35,489.50 / $168,000). The effective tax rate tells you more directly the percentage of your income that is paid in taxes. It can only be derived by knowing the actual amount of taxes paid.

Why Is Your Effective Tax Rate Lower?

All of your income is not taxed at the same rate. It is taxed in pieces, with the highest level of income being taxed at higher rates than the lower level income. That’s how tax brackets work. Whereas your effective tax rate is based on the actual dollars paid in taxes that was derived from the lowest all the way to the highest income tax brackets. You can think of ETR as an average of tax brackets.

What Affects Your Tax Bracket?

Not all the income you earned during the year is considered when determining your tax bracket. Any applicable deductions would reduce your taxable income which is what your tax bracket is based on. For example, if an individual earns a $75,000 salary but has itemized deductions that equal $15,000, then his tax bracket would be based on a $60,000 salary.

Deductions mostly impact your highest tax brackets. If your highest bracket is 35% then having $10,000 in deductions would save you $3,500 ($10,000 x 35%) in taxes. Same if your highest bracket is 22%, $10,000 in deductions would save you $2,200 ($10,000 x 22%) in taxes.

Deductions reduce your taxable income. Tax credits directly reduce your tax bill. Because of this, tax credits do not have an impact on your tax bracket. Tax credits have a bigger impact on effective tax rate since they reduce your taxes paid and therefore reduces your ETR.

Are Tax Brackets Fair?

The jury is still out whether or not tax brackets are fair. Some argue, that because higher income individuals have a higher tax rate than those with lower income, the system is unfair. A person making $400,000 a year has a bigger portion of their income being paid in taxes at a 35% tax rate. Whereas, someone making $40,000 has a lower portion of income going towards taxes at 22%. If both parties instead pay 25% each, would that be fairer?

On the flip side, others argue that the person earning $400,000 a year can afford to pay a higher tax rate than the person earning $40,000. Whichever way you agree with, the current tax system supports the latter argument: the more you make, the more you can pay.

Congress and those in government continue to debate this issue. Republicans tend to side with the idea that everyone (regardless of income) should pay lower or equal taxes. And by lowering taxes, people will, in turn, put that extra cash back into the economy. Democrats tend to believe if you earn more, you can pay more to help fund government programs and/or the economy.

As a taxpayer, what’s important is to understand the current law and current system. With this understanding, you should be maintaining a compliant relationship with the IRS by timely and accurately filing your tax returns and paying any applicable taxes.

What’s Next?

It’s not all bad news. Although people are considered apart of their highest tax bracket, we just learned that not all of your taxable income is taxed in your highest bracket. For a better picture of the percentage of income that you are paying towards, examine your effective tax rate.

Regardless or not if you believe tax brackets works best as a tax system, it is important to stay compliant on your taxes to avoid unnecessary penalties. One way to stay compliant is by hiring a tax professional to handle all of your tax affairs. Consider the tax services LYFE Accounting offers!