Tax Brackets

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Matt Soladay

Matt Soladay

Have you ever heard someone express concern about working overtime shifts because earning more money will push them into a higher tax bracket? Our tax system is progressive, so the taxes we pay increase as we make more money, however:

If you make enough money to push you up to the next tax bracket, that doesn’t mean that every dollar you have earned gets taxed at that higher rate.  Only those dollars in the higher bracket get taxed at that rate.

This is a very important distinction point and one that many people don’t fully understand.  Before we get into an example of how brackets work and the difference between effective tax rate and marginal tax rate, below is the IRS tax rate tables for reference. As you can see, high-income earners will pay a greater tax percentage than lower-income earners.

2021 IRS Tax Brackets

Let’s say that a Nurse Practitioner making $110,000 is unmarried (filing single). Below is a visual that will help illustrate their tax bracket, or for purposes of this example…a tax bucket. Each bucket represents a different tax rate, and the water level represents the associated income range.

Tax Bracket Visual Example, Tax Bucket example

The water fills the first three buckets, representing tax rates of 10%, 12%, and 22% because this NP makes more than the dollar range identified.  However, the 4th bucket is only partially filled because the income is less than that bucket’s capacity (tax bracket).  That 4th bucket can fit up to $164,925 based on the tax filing status, but only her income between $86,376 and $110,000 will be taxed at 24%.

In order to calculate how much this NP will pay in taxes based on $110,000 of taxable income, simply multiply the tax rate by the number of dollars earned in that bracket/bucket identified by the IRS:

10% Bracket: ($9,950-0) x 10% = $995
12% Bracket: ($40,525-$9,951) x 12% = $3,669
22% Bracket: ($86,375-$40,526) x 22% = $10,087
24% Bracket: ($110,000-$86,376) x 24% = $5,669.76

Total tax owed: $20,420.72

The 24% tax bracket can fit more than $110,000, but we stop there based on the earned income.  The total amount of tax owed for this example is $20,420.76.  Calculating this number also allows you to calculate your Effective Tax Rate.

Effective Tax Rate

Your Effective tax rate is essentially your average tax rate (unofficial term). To calculate it: take your total amount of tax owed from the above calculation and divide it by the total income.

($20,420.76) / ($110,000) = 18.56%

This calculation reveals that overall, the NP is taxed 18.56% from the federal government on her taxable income of $110,000. 

Marginal Tax Rate

Your marginal tax rate is based on how any additional income earned will be taxed.

In the previous example of the NP that made $110,000, her marginal tax rate would be 24% but effective tax rate is 18.56%. If the NP found a job that made as much as $170,000 a year, her marginal tax rate would increase to the next bracket, at 32%.

Knowing what your marginal tax rate is can help you estimate your tax bill as well as identify ways to lower your taxable income.

Reduce Your Tax Bill

The three biggest strategies to lower the amount of tax you pay are:

  1. Tax Deferrals
  2. Tax Deductions
  3. Tax Credits

Tax deferral is when you defer or delay paying taxes for another time.  Such as when we contribute to our retirement accounts.  It’s not that we will never pay taxes on the money contributed, but we are putting off the taxation until our lower income/retirement years.  For example:  if you are a dual-income household making $211,750 gross (total) income, that would put you into the 24% tax bracket if you filed jointly.  However, if both spouses maxed out their retirement accounts at $19,500 each, they would reduce their taxable income by $39,000.  This would bring their taxable income down to $172,750, which is the top of the 22% bracket.

To calculate how much their taxes were reduced, simply multiply the total number of dollars that were deferred by the tax rate of that tax bracket:

($19,500 + $19,500) x 24% = $9,360  

Not only would they pay almost $10,000 less in taxes, but they are also making tremendous progress towards retirement. Tax deductions reduce your total taxable income like a deferral does; however, the big difference is that you never have to pay the tax you avoided when you use a deduction.  To calculate the amount you save when performing a deduction, it is the same process as a deferral. If the NP example making $110,000 took the ‘standard deduction’ available to single filing status of $19,550, then the amount saved on taxes would be:

$12,550 x 24% = $3,012

The most common deductions used are:

  • Standard IRS deduction (most common)
  • Itemized deduction for higher incomes or small business owners
  • Home office
  • HSA or FSA contributions
  • Contributing to your child’s 529/college savings plan
  • Student loan interest deduction
  • Mortgage interest deduction

Tax credits, on the other hand, reduce the amount of tax owed dollar for dollar.  For example, if you have a tax bill of $3,000 and take advantage of a $1,000 tax credit, you would only owe $2,000.  It is much more efficient at lowering your tax bill, but credits are not a plentiful as deductions.

The most common types of tax credits:

  • Earned income tax credit
  • Child and dependent tax credit
  • Adoption credit
  • Lifetime learning credit
  • American opportunity tax credit

Questions or comments below…

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Rebecca Richardson
Rebecca Richardson
1 year ago

Really like this post. You did a great job at explaining how tax brackets work.

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