How Exactly Do Tax Brackets Work? Here’s What Everyone Should Know

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Understanding Tax Brackets

You’ve probably heard stuff about tax brackets on the news or on social media at some point and wondered how the heck all that stuff even works. To be honest, there are plenty of misconceptions and misunderstandings when it comes to tax brackets so we don’t blame you if you’re confused.


A 2019 study by CNBC said that 48% of Americans did not know what tax bracket they were in.


So, if you don’t know much about tax brackets, don’t worry you’re not alone.

This may sound like a boring topic to some of you. But it’s important to learn about taxes and how they affect you because a solid understanding will help your long-term financial planning and can even help us all make educated political decisions.


A Common Misconception

To find out what Federal Tax Bracket you’re in, you can do a simple Google search. Just make sure you’re looking at the correct year. Take a look at this chart of the Federal Tax Brackets for 2021:

You may look through this chart and think something like, “ I make $42,000 a year so I’m in the 22% bracket... Oh my god, I’m paying 22% of 42,000!? THAT’S LIKE 9,000 DOLLARS! ”

Wrong. This is a common misconception that people don’t understand. In this case, you would not actually pay a full 22% of your $42,000 income.


This type of thinking makes some people scared to get a raise at work because they think they’ll have to pay more in taxes. This would be incorrect and is a terrible belief to have. So here’s the real truth...


There’s good news and bad news. The good news is that you will most likely pay less than the full percentage of what you see in the bracket you fall in. The bad news is that it takes a little time to calculate and understand what you actually owe.


The Amount You Really Owe

The United States tax system is a “progressive tax system.” This means different portions of your income are taxed at different rates.

The government decides how much taxes you owe by separating your income into chunks — AKA tax brackets — and each chunk gets taxed at its respective rate.


Confused?


To put this in simpler terms, think of tax brackets like different-sized pockets that are taxed at different rates depending on how much money they can each fit inside them.

To understand what you really owe in taxes, you must understand these three concepts:

  1. Taxable Income

  2. Marginal Tax Rate

  3. Effective Tax Rate

But don’t be intimidated! These are just terms that you can easily understand with a few examples.


Taxable Income

Fun fact: You actually don’t pay taxes on your total income.


Your taxable income is what it sounds like - your income that is subject to taxation.


There are quite a number of factors that can affect your taxable income, so we won’t go over the details in this article. But for now, it is important to understand that not all of your income will be taxed.


Your taxable income is what will apply to you when looking at tax brackets. So if you look back to our tax bracket chart, if you’re filing single and your taxable income is $80,000 then you would be looking at 10%, 12%, and 22%.


“But wait, why am I looking at 3 tax brackets??”


This leads us to our next topic, the Marginal Tax Rate.


Marginal Tax Rate

By definition, your marginal tax rate is the amount of tax paid on each additional dollar of income.


Example:

So, let’s refer back to our tax bracket table for 2021 and say that Johnny is filing single and his taxable income for the year is $41,000.

  • For Johnny’s first $9,950 he would be taxed 10%.

  • Then 12% on his earnings from $9,950-$40,525.

  • And then 22% on every dollar he makes over $40,525.

So in this example, only $475 (41,000-40,525) of Johnny’s taxable income would be charged at 22%.


The 22% would be Johnny’s marginal rate because that’s the percentage he’s paying on each additional dollar he earns.


As you can see, the actual tax rate you are paying is less than the marginal rate.

This leads us to our next topic, The Effective Tax Rate (AKA your actual tax rate).

Effective Tax Rate

Your Effective Tax Rate is the actual percentage of your income that you will pay in taxes.


Example:

Let’s say that Jim and Pam are married filing joint returns.


Together their taxable income is $90,000 after deductions. And let’s say after filing their taxes, they pay a total of $9,000 on their federal tax bill.


To find Jim and Pam’s Effective Tax Rate we would divide their tax bill by their total taxable income:


$9,000 / $90,000 = 10% Effective Tax Rate


Keep in mind that these numbers are just an example and probably won’t accurately reflect a real-life scenario. But the math here will always stay the same.


The Effective Tax Rate is often looked at as the more important tax rate to look at between the two. This is because the marginal tax rate only refers to the highest tax bracket that applies to you and doesn’t show what you’re really paying in taxes.


Hope You Learned Something New

Remember, tax brackets are decided at a state and federal level. This means that tax rates can change from year to year. This is another reason to dedicate some time to understanding tax brackets and how they affect us all.


Our progressive tax system can be easy to understand if you just give it some time. After reading this article, hopefully, you understand what you’re looking at when you pay your taxes. And now, whenever someone says something about how they hate a politician because they are getting taxed 30% of their income, you can share this article with them.


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