When it comes to income tax, the United States is one of the most progressive nations. But, even with a progressive system, many Americans still pay little or no federal income taxes.
Tax rates and brackets are based on taxable income, which is adjusted for deductions and credits. The actual percentage of your taxable income that ends up going to the IRS is called your effective tax rate.
Tax Brackets
The United States has seven tax brackets for most ordinary income: 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent. Each bracket includes a range of taxable income, and each increase in your taxable income will result in an increase in the federal tax rate you pay.
Tax brackets are not as intuitive as they may seem. For example, if you are in the 37% bracket, that doesn’t mean that all of your income is taxed at 37%; instead, only a certain amount of your income is subject to the top marginal tax rate. The rest of your income is taxed at a different rate, often much lower. This lower tax rate is sometimes referred to as your effective tax rate.
The tax rates for each bracket do not change from year to year, but the income thresholds that determine which tax bracket you are in are adjusted yearly for inflation. This is done to offset “tax bracket creep,” a phenomenon where Americans pay more taxes as their wages rise without corresponding economic benefits.
Your actual tax rate will vary depending on where you earn your money, how it’s broken down, and what deductions are available to you. For example, if you are in the 37 percent tax bracket and have a $200,000 salary, your effective tax rate will be higher than if you were in the 2023 26 percent bracket.
The best way to determine how much you will actually be charged in taxes is to calculate your total income tax by dividing your income tax bill by your total annual earnings. Using this figure, you can begin to make plans for implementing smart tax strategies, like adjusting your income tax withholdings, to reduce your tax bill in the future. This will also allow you to avoid a large, unexpected tax bill come April. If you are unsure about your taxes, consulting with an accountant or tax lawyer is the best course of action. There are also a number of free online calculators that can help you estimate your tax liability.
Taxable Income
Whether you work for someone else from 9 to 5 or you’re self-employed, you’re required to pay taxes on your earnings. However, the tax code can be complicated, and many people don’t fully understand what counts as taxable income and how it varies depending on filing status, deductions, and other factors.
The term “taxable income” refers to the portion of your adjusted gross income, or AGI, which is subject to individual income taxation. AGI is calculated by adding up your total compensation, including wages and salaries, tips, and bonuses, as well as investment income and various types of unearned income. Taxable income is reduced by your itemized or standard deductions, which vary based on your filing status.
Your state and local governments also levy income taxes. These levies are usually a percentage of your taxable income. Taxable income is the starting point for determining your individual tax liability and determines the size of your tax bracket and marginal rate.
Federal income taxes are progressive, meaning that your tax rate increases as your taxable income rises. Generally, the top marginal rate is levied on income above $518,400 for single filers and $622,050 for married couples filing jointly.
To calculate your taxable income, you’ll start with your total compensation for the year, which includes wages, salaries, tips, and any fringe benefits you receive, such as health insurance and retirement contributions. Then, you’ll subtract your allowable deductions, such as the personal exemption (when available), the standard deduction, and the amount of your itemized deductions.
Almost all forms of income are considered taxable, including interest and dividends, capital gains, rental property income, business profit sharing, and unemployment compensation. However, certain types of income are considered nontaxable, such as gifts, inheritance, and alimony payments. Other nontaxable forms of income include welfare and workers’ compensation payments. If you’re unsure if a particular form of income is taxable, consult your tax adviser.
Taxable Deductions
Taxable deductions are a great way to lower your taxable income. Depending on your situation and filing status, you can choose to either claim the standard deduction or itemize your deductions. Deductible expenses include mortgage interest, charitable contributions, and unreimbursed medical expenses. You can also deduct state and local taxes, property taxes, and some foreign taxes.
The IRS sets the standard deduction amount each year, which is subtracted from your taxable income. It’s a great option for taxpayers who don’t have enough deductions to itemize their deductions. This year the standard deduction is $12,950 for single taxpayers, $19,400 for head of household, and $25,900 for married couples filing jointly.
If you decide to itemize your deductions, you must have records and receipts to back up each of the items you’re claiming. This can be a hassle for many taxpayers, especially since the rules around deductible deductions can be complex and subject to change each year.
The main advantage of itemizing is that it can result in a larger tax refund or a smaller tax bill than the standard deduction. For example, if you have high unreimbursed medical expenses or a large amount of state and local taxes, you can save money by taking the itemized deduction instead of the standard deduction.
While the deduction reduces federal tax liability for many taxpayers, some argue that it unfairly subsides for state and local governments, which already receive substantial federal funding for education, health, public welfare, and infrastructure. Furthermore, critics point to the fact that the vast majority of taxpayers benefiting from this deduction are in the top 20 percent of income earners.
A small business owner must carefully weigh the pros and cons of claiming itemized deductions. Although a few of them can significantly lower a business’s taxable income, others may be counterproductive in the long run. The best way to determine whether it’s beneficial to itemize or not is to speak with a tax or accounting professional.
Filing Status
Filing status is one of the most important factors in determining your tax brackets, standard deduction, and eligibility for certain credits. It’s also used to calculate your phase-out income for deductions such as personal exemptions, which is why ensuring you have the correct filing status before filing is important.
There are five different filing statuses: single, married filing jointly, married filing separately, head of household, and qualifying widow(er) with dependent child. Each has its own rules and benefits, so it’s critical to know which one you have before deciding how to file.
The IRS has a tool that will help you determine your filing status. It asks you a series of questions about your marital status, spouse’s year of death, and household (including food and utilities). The tool then recommends the filing status that will give you the lowest tax liability.
For 2022, the tool recommends filing as Head of Household for those who are unmarried on the last day of the year, paid more than half the cost of keeping up a home, and have a qualifying person living with them (typically children). Head of household is particularly beneficial for single parents because it allows you to claim a larger standard deduction ($19,400 vs $12,950 for single filers) and has more generous tax brackets.
Married filing jointly is typically the preferred filing status for couples with similar income levels. This is because it allows for a lower overall tax burden and can reduce the amount of taxes withheld from each paycheck by having fewer allowances taken out. Married individuals with different incomes may also prefer this status because it provides more flexibility in determining how much to pay in taxes, as they can elect the percentage of their income that will be withheld.
However, there are disadvantages to this filing status as well. For example, if a couple chooses to file jointly, but one spouse earns significantly more than the other, the higher-earning partner will have to pay a significant portion of the additional taxes. This is known as the “tax wedge” and is one reason some people file separately.
