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Tax Brackets

Marginal Tax Rates: Here's How They Work

Tax brackets are certainly a hot topic, especially around tax season; however, there can be a lot of confusion about how they work. A common misconception is that if you get bumped into a higher tax bracket, your entire income will be taxed at the higher rate. The good news is that this is not true. Federal taxes are marginal, which means that only certain portions of your income are taxed at certain rates.

Think of tax brackets as baskets (Figure A) containing your income. When one basket gets full, the remaining balance get placed in a new basket...or tax bracket. The tax rates shown here show percentages of 10, 12, 22, 24, 32, 35, and 37 percent with the applicable income levels based on marginal tax rates for 2022.

7 baskets increasing in size representing tax bracket percentages of 10, 12, 22, 24, 32, 35, and 37 percent with corresponding income levels based on 2022 marginal tax rates for an individual filer.

Figure A: This example is for an individual tax return based on 2022 marginal tax rates. Different tax brackets or “baskets” exist for joint filers and rates vary year by year.


three baskets representing the tax brackets, 10, 12, and 22 percent containing 10,275 dollars, 31,500 dollars, and 40,275 dollars respectively.
Figure B: Example of an individual filer's taxable income

Here is an example of an individual filer making a gross income of $95,000 (Figure B)After a standard deduction of 12,950 and no other income reducing items, the

taxable income ($95,000-$12,950) of the individual is $82,050. The first $10,275 in income is taxed at 10%, the next $31,500 is taxed at 12%, and the remaining $40,275 is taxed at 22%. A more detailed example is given in this short video. 

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Since portions of our income get taxed at different rates, the actual rate or “effective tax rate” is typically less than the highest marginal tax rate. There are other factors that can reduce or increase your taxable income, so it’s more complicated than simply taking an average. To calculate the effective tax rate, you’d have to consider all the factors that impact your taxable income. Some, but not all, items that may reduce your taxable income are the following:
  • IRA contributions
  • Student loan interest
  • HSA contributions
  • Charitable donations
  • Medical expenses
  • Business expenses
After considering all factors, you would then divide the total taxes you paid by that figure to get your effective tax rate.
 
Effective Tax Rate = Total Taxes Paid ÷ Taxable Income

Let’s Team Up
Taxes can be one of your household’s largest expenses. If you have questions or are looking for strategies to reduce your taxable income, we can help. Remember, when it comes to taxes, always consult your tax professional for the most up-to-date information and changes. Working with a tax professional and a financial advisor can help you be better prepared when tax season arrives.

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