Mastering Tax Brackets for Better Financial Planning: How Progressive Tax Bracket Work
Understanding how the US tax system works is a critical component of providing effective advice as taxes play a notable role in many areas of your financial picture.
Tax planning is one of those topics that is interwoven into many other financial planning topics. From understanding the tax implications of various savings strategies to the tax implications of estate distributions, having a solid understanding of how taxes work can help make better decisions.
While nearly everyone files taxes every year (yes, there are a few who might not need to), many do not have an understanding of basic, foundational tax concepts. This article dives into how tax brackets work in the US and draws out several key concepts that will help you better understand your tax picture.
Tax Brackets like a Science Beaker
Tax brackets indicate the rate at which each additional dollar of income is taxed, which can sometimes lead to confusion among taxpayers. The common misconception is that moving into a higher tax bracket will cause all income to be taxed at that higher rate.
However, the US uses what’s called a progressive tax system which means that, in general 1, lower levels of income are taxed at lower rates and higher levels of income are taxed at higher rates. Let’s take a look.
A good way to think about the progressive tax system is to think of a science beaker. For the most part 2, everyone starts the year out with an empty beaker. As you earn income, you pour that income (liquid) into the beaker. Over the course of the year, you’ll keep adding income to that beaker until you have accounted for all income that you generate.
Beginning of the Year
End of the Year
How does this relate? Regardless of how much income you add to the beaker, you’ll notice that every beaker will have income at the bottom of the beaker. Whether you have $10,000 of income or $1,000,000 of income, the first part of that income goes in the bottom and subsequent income goes on top. The income then is broken down into where it falls in that beaker and taxed at the applicable tax rate for that level.
Someone with $10,000 of taxable income will have their $10,000 taxed at the same rate as the first $10,000 of income for the person who has a total income of $1,000,000.
It’s important to stop here and note that these rates apply to Taxable Income not necessarily total income. The tax system contains many deductions and exclusions that reduce total income down to the taxable income. The most universal of these is the Standard Deduction.
How the Tax Brackets Work
For the purposes of our examples, I will use the Married Filing Jointly tax brackets as it relates to ordinary income. There are different tax brackets related to different tax filing status’ (single, head of household, married filing separately), and different tax brackets for different income (ie, capital gains).
2024 Married Filing Jointly Tax Bracket
| Income Over | But Not Over | Tax+ | % on Excess | Of the Amount Over |
|---|---|---|---|---|
| 0 | $23,200 | 0 | 10% | 0 |
| $23,200 | $94,300 | $2,320 | 12% | $23,200 |
| $94,300 | $201,050 | $10,852 | 22% | $94,300 |
| $201,050 | $383,900 | $34,337 | 24% | $201,050 |
| $383,900 | $487,450 | $78,221 | 32% | $383,900 |
| $487,450 | $731,200 | $111,357 | 35% | $487,450 |
| $731,200 | - | $196,670 | 37% | $731,200 |
The table above describes the different tax bracket thresholds (lines on the science beaker) and the different tax rates applied. Everyone using this bracket will have their first $23,200 of income taxed at 10%. Any income above $23,200 will then be taxed at 12% up to $94,300 of income. This continues on down the table until all of your income is fully taxed at a given bracket.
Here is how to quickly apply the table to your taxable income:
- Find the row with your income range listed in column 1 (Income Over) and column 2 (But Not Over).
- Subtract your taxable income from the last column.
- Multiply that result by the rate in column 4 (% on Excess).
- Add the result in step 3 to the base tax amount in Column 3 (Tax+).
Examples
$50,000 Taxable Income
In the below chart, $50,000 of taxable income fully fills up the 10% tax bracket and moves into the 12% tax bracket. In this case, $23,200 of income is taxed at 10% resulting in $2,230 in taxes and $26,800 is taxed at 12% resulting in $3,216 in taxes.
The total tax bill is $5,536 for the year.
$250,000 Taxable Income
In the below chart, you can see the $250,000 of taxable income fully fills up the 10%, 12%, and 22% tax brackets. In this case, the first $23,200 is still taxed at 10% but then subsequent brackets add on additional taxation (12% adds $8,532, 22% adds $23,483, and 24% adds $11,748).
The total tax bill is $46,085 for the year.
*Numbers and charts generated by author using proprietary software.
Marginal Tax Rates
Marginal tax rate is essentially how much tax you pay on the next dollar earned.
It governs how much income you would need to generate in order to net a specific dollar value after-tax.
For example, let’s assume that you wanted to generate $5,000 after-tax to pay for a vacation and you only have a Traditional IRA with 100% pre-tax money.
Taking the $50,000 example from above, the $5,000 of additional income would fall entirely in the 12% tax bracket. In this case, the marginal tax bracket is 12% so just withdrawing $5,000 would generate $600 of taxes. To net $5,000, you would have to withdraw $5,681.82 to cover the expense.
Taking the $250,000 example from above, the $5,000 of additional income would fall entirely in the 24% tax bracket. In this case, the marginal tax bracket is 24% so just withdrawing $5,000 would generate $1,200 of taxes. To net $5,000, you would have to withdraw $6,578.95 to cover the expense.
Marginal Tax Brackets in real life is more complicated than this simple illustration. To calculate your true marginal tax bracket, you have to factor in state and local taxes, what income is phased in or phased out, and what deductions or credits you earn or lose.
Effective Tax Rate
Effective Tax Rates represents what percent of your income did you pay in taxes. The effective tax rate combines all of the taxes from the different brackets, deductions, credits, and thresholds and simplifies it into a single number.
It is calculated by taking your total tax bill divided by some measure of your income. Most often, taxable income is used to calculate this effective tax rate but you could also use Adjusted Gross Income or Unadjusted Gross Income.
For example, the $50,000 income example has an effective tax rate of 11.07% ($5,536 divided by $50,000). At $250,000 of income, the effective tax rate is 18.43% ($46,085 divided by $250,000).
Footnotes
- When you apply the full tax code including all of the deductions, credits, phaseouts, phase ins, and more, there can be areas of the tax system that are not progressive but regressive meaning areas of higher income is taxed at lower rates.
- You can start with "negative income" if you have carryover deductions from prior year losses.