As Albert Einstein said, "The hardest thing in the world to understand is the income tax." While he may have meant this figuratively, its literal meaning is also very present. Many people need clarification on our tax system due to its complexity, which stems from numerous rules, deductions, credits, and varying tax rates. The ever-changing tax laws and regulations also contribute to this confusion, making it challenging for individuals and businesses to navigate and accurately calculate their tax obligations.
Tax brackets are a way in which income taxes are calculated. The basic idea behind tax brackets is that your income is divided into different portions, and each portion is taxed at a different rate. Each income category or bracket is associated with a specific tax rate, expressed as a percentage. Our tax system is progressive, meaning the tax rates increase as you move into higher income brackets. The idea is that those with higher incomes pay a higher percentage of their income in taxes. Please see the chart below for reference. If you file a single tax return, your standard deduction and bracket thresholds are on the left, and married filing jointly is on the right.
The below graphic is based on the 2022 Standard Deduction.
When you earn income, your total income falls into one of these federal brackets based on how much you make during a given tax year. To calculate your income tax liability, you remove your standard deduction and apply the corresponding tax rate to the income within that bracket. For example, if you earned $150,000 of earned income as a 66-year-old single filer- you would first remove the standard deduction of $13,850 and then an additional $1,850 because you are over 65. This would make your taxable income $134,300, which would be in the middle of the 24% tax bracket. Looking above, you would only pay 24% on the $38,925 above the 22% bracket.
It's important to note that not all income is taxed at the same rate. Different types of income, such as Social Security, capital gains, dividends, and earned income, have different tax treatment within the overall tax system.
Understanding your tax bracket can help you minimize your overall tax liability by making smart financial decisions, such as Roth conversions, when you are in the lower tax brackets. Knowing your bracket also allows you to plan for tax-efficient retirement savings and withdrawal strategies. We are happy to discuss this further if you would like to learn more about potentially maximizing your tax bracket!
*The above paragraph is based on 2023 Standard Deduction. Please note the Single or married filing separately — $13,850. Head of household — $20,800. Married filing jointly or qualifying surviving spouse — $27,700.