I frequently have calls from taxpayers who want to know, “What is my tax bracket?” Quite often I get the impression they want this information to share with a friend or at some social function rather than use it to make prudent investment or business decisions.
For example, a taxpayer may know that he or she is in the 30% tax bracket but does not understand how to use that information when making a decision about whether to fund an IRA. Knowledge about one’s tax bracket provides the basis for determining the tax effect of taxable transactions.
Where Do Tax Brackets Come From?
Congress establishes tax rates that apply to different levels of taxable income. Current law provides rates from 10% to 35% for the year 2012. The following table indicates the brackets that apply to single individuals (other than heads of households and surviving spouses):
|
Taxable Income Is Over
|
But Not Over
|
The Tax Is
|
Plus
|
Of the Amount Over
|
|
$0
|
$8,700
|
—
|
10%
|
$0
|
|
$8,700
|
$35,350
|
$870.00
|
15%
|
$8,700
|
|
$35,350
|
$85,650
|
$4,867.50
|
25%
|
$35,350
|
|
$85,650
|
$178,650
|
$17,442.50
|
28%
|
$85,650
|
|
$178,650
|
$388,350
|
$43,482.50
|
33%
|
$178,650
|
|
$388,350
|
—
|
$112,683.50
|
35%
|
$388,350
|
You will notice that rates increase as income increases. The range of income where the individual stays at any particular rate is known as a tax bracket. For example, a single individual, who has taxable income of more than $35,300, but not over $85,650 in 2012, is in the 25% tax bracket.
Common Misconceptions About Tax Brackets
There are several notable misconceptions and points of confusion with respect to tax brackets.
Tax Brackets and Earnings
An individual’s tax bracket is determined by taxable income, NOT gross income. Therefore, earnings (i.e., salary or self employment income) are not the only factor that causes a taxpayer to move into a different tax bracket. For example, increased investment income, pension distributions or even a decrease in deductions can cause a change in tax brackets. Retired persons are often unsuspecting of the impact a one-time change in income can have on their tax bill. The increased income often pushes them into a different bracket, and at the same time, subjects their social security benefits to income taxation, which further compounds the problem.
Sudden Change in Tax
Movement into a higher tax bracket does not necessarily mean that an individual will suddenly have a huge increase in tax. For example, if current taxable income is in the 25% bracket, but just a few dollars away from the 28% bracket, movement into the higher tax bracket does not automatically precipitate a huge increase in tax. The individual’s tax bill increases by $28 for each $100 of taxable income that falls into the higher bracket. Taxable income below the 28% bracket threshold continues to be taxed at the respective rates of the brackets into which it falls.
Tax Brackets and Withholding
Taxpayers often confuse tax brackets and withholding rates. The relationship between an individual’s tax bracket and the amount of employer withholding is very indirect. Withholding rates are based upon averages rather than specific tax brackets. For example, your withholding rate can be about 20%, even though there is no tax bracket between the 15% bracket and 25% bracket.
Tax Brackets and Marginal Rates
In some cases, the percentage increase in tax an individual pays when their income increases is not the same as their tax bracket.
A taxpayer’s taxable income might fall very close to the breaking point between two brackets. Additional income or loss of deductions could push a portion of the increased taxable income into a higher bracket, causing the taxpayer’s marginal rate to be higher than the existing bracket rate.
Example: In 2012, a single individual with $35,350 in taxable income is in the 25% bracket. The tax on an additional $300 of taxable income amounts to $75.
How to Determine Your Tax Bracket
Determining your tax bracket involves two steps:
- Determine your taxable income.
- Look up that number in the applicable tax rate schedule (not tax tables).
If you refer to the initial example at the beginning of the article, you see that any single individual, who has taxable income of more than $35,350 but not over $85,650 in 2012, is in the 25% tax bracket.
Taxable income for a previous year can be found by referring to the line labeled “taxable income” on Form 1040 for that year. If taxable income for the current year is expected to be significantly different, start with the taxable income from the previous year, and make adjustments for anticipated changes.
Be careful! There are different tax rate schedules for single individuals; married persons filing jointly or as a surviving spouse; married individuals filing separately, and individuals filing as head of household. IT WILL MAKE A DIFFERENCE IF YOU USE THE WRONG TABLE!
If you would like further information regarding this issue as well as any other tax related issue, please contact Henssler Financial at 770-429-9166 or at experts@henssler.com