How Do Income Tax Brackets Work?

The tax code, despite calls for countless reforms to make it fairer or simpler, remains intensely complicated due to tax incentives, politically inspired loopholes, complicated filing situations in today's evolving family dynamics and many other pressures from corporate interests, consumers, political parties and special interests. These tax intricacies confuse many people and easily lead them to make mistaken assumptions based on rumors, TV shows and often-repeated sayings such as: "A raise wouldn't help; it'd just put me in a higher tax bracket." One of the most pervasive misconceptions is regarding how tax brackets work. Some people think that getting into a higher bracket means that all their income is taxed at the higher rate, but the IRS uses a progressive tax system that taxes money above certain limits at the higher rate while continuing to tax the income below that amount at the lower rate.

A practical example illustrates how progressive tax brackets work. If your adjusted gross income totals $100,000, your tax would be calculated like this in 2016 for a single filer:

• The first bracket calculation applies the 10-percent tax to the first $9,275 of income or a total tax of $927.50
• The second bracket of 15 percent applies in full to $28,375 or your income, which generates tax of $4,256.25.
• $100,000 also covers the 25-percent bracket fully for $53,500 at 25-percent tax or $13,375.
• There is $8,850 remaining income that's subject to the 28-percent bracket rate or $2,478.
• Your total tax would be $927.50 + $4,256.25 + $13,375 + $2,478 or $21,036.75.
• If you're counting your money, that's $9,275 + $28,375 + $53,500 + $8,850m which equals $100,000.
• If your highest tax bracket applied to the whole income, your tax would have been $28,000.
• $100,000 when calculated at progressive bracket rates yields an effective tax rate of 21.04 percent or $21,036.75 divided by $100,000.

You effective rate can vary considerably from bracket rates depending on your tax credits, deductions, ability to deduct retirement payments, accelerating or delaying income and expenses, whether you have tax-exempt or tax-advantaged income and whether your income also is subject to the alternative minimum tax or AMT. As you can see in the above list, you don't pay the full 28 percent that applies to your AGI income over $91,150 but only on $8,850 of the money that goes over the previous bracket's limit of $91,150. At each of the lower brackets, you pay the applicable rate up to the maximum limit in that particular bracket. These rates are automatically incorporated into the appropriate tax table depending on your filing status and your AGI or adjusted gross income after certain allowable deductions. You can use a tax calculator to calculate your expected refund, calculators can handle many different variables and situations. Take out the guess work and plan ahead with this tax calculator tool.

Latest Tax Bracket Information

This post was written in 2018, regardless of your tax bracket or the number of tax brackets your income crosses, the tax that you actually pay depends on averaging your real-world taxes against your total income to get your effective tax rate. This figure varies among taxpayers based on their decisions, credits, tax-exempt income, capital gains and other tax return details. Parts of your income are taxed at different rates, and there are seven brackets or progressive tax rates for regular income in 2016: 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, 35 percent and 39.6 percent. There are also two tax rates for long-term capital gains: 15 and 20 percent. These figures are applied progressively to income, so going just one dollar over means that only one dollar is taxed at the higher rate. What should concern taxpayers is going many thousands or millions of dollars over and exposing that income to higher tax rates.

Another major concern of high-income earners is the new Medicare surtax of 3.8 percent on investment income or long-term capital gains. [1] That means that the highest wage earners are subject to a top tax rate of 39.6-percent income tax plus 3.8-percent capital gains Medicare surtax, so your maximum rate could be 43.4 percent, but that rate will only apply to the part of your income that's capital gains. Capital gains were previously nontaxable for Social Security and Medicare, but the new taxes were imposed to deal with the funding shortages for Medicare and its ability to pay for provisions of Obamacare.

There are ways to manage tax brackets and shift income so that it doesn't always get taxed at higher rates. Savvy taxpayers from all tax brackets can invest in retirement and insurance products, take advantage of all the legal deductions available to them, invest in tax-free and tax-advantaged investments like municipal bonds and employ proactive business strategies to reduce their taxes such as creating S corporations or limited liability corporations. These efforts can result in significantly reduced effective tax rates when comparing total tax to total income.

Each year, the IRS adjusts its tax brackets for inflation based on the Consumer Price Index, so there's little change from 2015 to 2016. Taxes apply to adjusted gross income, and as mentioned, tax rates are progressive so that your tax rate changes only on the amount above certain limits. The following table shows the effective tax brackets for 2016:[2]

Real-World Effects of Higher Tax Brackets

Despite the graduated effect on taxes of progressive tax brackets, taxpayers can still benefit by being aware of higher brackets, adjusting their incomes where possible to receive the best tax rates and lowering or deferring taxes through itemized deductions, proactive business tax strategies, retirement investing, insurance products and other tax avoidance strategies.

The tax code contains many income limits, phaseouts and increased taxes beyond certain income boundaries. Filing your taxes with software is the easy part of tax planning, and the more you earn, the more important it is to hire an accountant or tax specialist who understands the tricks and tips of reducing your tax burden, shifting income, generating benefits for your family tax-free or tax-advantaged and putting pretax dollars to work for you earning interest. Proactive planning can shift enough income to generate substantial tax savings based on keeping large parts of your income out of higher tax brackets.

Additional concerns of families whose income falls between $100,000 and $300,000 include possibly losing the tax benefits of financing college educations for children, paying additional Medicare taxes and becoming subject to the 3.8 percent capital gains surtax and alternative minimum tax. Tax brackets just don't tell the complete story because the middle 20 percent of U.S. taxpayers pay an average of 13 percent in federal taxes, and many people pay less or nothing while others pay more than 30 percent.[3] That's because taxpayers can adjust their taxes with proactive planning and the following tax avoidance strategies:

• Contributing to Retirement Accounts
  Putting money in an IRA or 401(k) plan provides an immediate tax deduction in the current tax year and allows you to earn tax-deferred interest on money that would otherwise go to the government. Leveraging pretax dollars and using other people's money are the best strategies for building wealth and financial security. You might be in a 25 percent bracket now but withdraw your savings in a 15 percent bracket.
• Managing the Sales of Assets Strategically
  There are many strategies for selling assets and realizing capital gains, which include taking a loss to neutralize a gain from another sale, reinvesting in similar asset types within prescribed time limits or spreading the sale of assets over a longer period to keep gains within lower tax brackets.
• Deferring and Accelerating Income
  Any taxpayer with multiple sources of income -- such as a business, real estate investments or self-employment income -- can bill customers faster or delay billing them to adjust income to keep it in a lower tax bracket. If you use the cash accounting method, you don't have to pay taxes until you receive payment. You can also increase your deductions by taking business losses, shifting income allocation within business partnerships, accelerate paying certain business expenses or deferring bill payments in years when you're likely to stay in a lower tax bracket. In some cases, you might want to get in a higher bracket deliberately, such as the 25-percent bracket, if you suspect you’ll be in an even higher bracket next year.
• Making Charitable Contributions
  If you make charitable contributions, you can use them to reduce your tax burden or realize tax deductions for investments you no longer want to keep.
• Hiring Family Members
  Hiring family members allows you to shift part of your income to family members who are probably in lower tax brackets. You can also take advantage of using your business to provide fringe benefits that are fully deductible against your income.
• Establishing Your Own Insurance Company
  If you own a large business, you can establish your own Closely Held Insurance Company or Captive Insurance Company. This approach works for wealthy people who own companies worth multiple millions of dollars with excellent cash flow. You could expense up to $1.2 million in insurance premiums that aren't subject to tax and use the money to establish a trust for your heirs.[4]

Tax Bracket Myths and Misconceptions

Tax brackets are the basis for many myths and misconceptions that people stubbornly cling to instead of making real efforts to take control of their finances and use the tax laws to their advantage. Sure, it's not easy to muddle through the tax code and keep up with changes each year, which is probably why people repeat the following myths even when many of them know or suspect that these stories aren’t true:

Myth #1: Tax-Bracket Rates Apply to All Your Income

If that were true, earning a single dollar could raise your taxes by thousands, and that's just not the case. Tax brackets cover ranges of earnings, and the income within that range is taxed at that rate. Each dollar above a given range is taxed at the higher rate.

Myth #2: A Raise at Work Means that You Net Less Money

A raise often triggers higher withholding taxes, and it could disqualify you for benefits like earned income advance credit if you're a lower wage earner, but people always earn more money after getting a raise. It's possible that you won't see a big difference due to tax withholding, but the extra cash will eventually be available.

Myth #3: Income Taxes Rates Always Rise

Throughout history, government spending and taxes have adjusted to market conditions, wars, social spending initiatives and deficits, but today's tax rates are among the lowest rates in the past 100 years -- especially for wealthier taxpayers.[5] Periods of low tax rates usually follow periods of high tax rates and vice versa as governments adjust to market fluctuations and other criteria, so historical analysis does indicate that taxes are likely to rise in the future.

Myth #4: Poor People Pay More taxes than the Rich

Although clever tax planning can cut taxes and shelter income, the Alternative Minimum Tax was passed in the 1960s to address the issue of well-to-do taxpayers not paying their fair share of taxes. The IRS uses a marginal system that taxes low-income earners little or no tax and even provides them credits for earned income. The more money that you earn, the higher the tax rates that apply to income over certain bracket limits. However, regardless of which bracket you're in, you can use money-sheltering techniques and other proactive strategies to reduce the effective tax rate that you pay relative to your income.

Myth #5: Marginal Rates Discourage Productivity and Self-Betterment

Some critics argue that marginal tax rates discourage people from bettering their prospects and trying to earn more money, which is maybe the silliest myth of all. The progressive tax system never results in people earning more and taking home less pay, and adults just don't think about earning proportionately less but concentrate on taking home more cash. Everybody has bills, mortgages and living expenses, so most people work hard to earn more money and take every opportunity to get ahead. There are essentially three ways to do so: earning more, paying fewer taxes on what you do earn and reducing your expenses.

Myth #6: Tax Preparers and Accountants Charge for Services You Don't Need

Although this might be true for low-income people who get all their withholding taxes back, even some of them might not be aware of a tax credit that's available. The convoluted tax code requires an expert planner who specializes in keeping up with its changes, legal requirements and loopholes that allow you to pay less tax. Most people get bigger refunds and pay fewer taxes when they hire financial help.

AMT and Bracket Creep

The alternative minimum tax is something that affects single filers in 2016 who earn more than $53,900 or married filers filing jointly earning $83,800.[6] This tax, which has long pushed people into paying more taxes, was designed to prevent rich people from taking advantage of tax loopholes and paying little or no tax. AMT requires making separate tax computations where certain key deductions aren't allowed. The AMT rate is calculated at a 26-percent or 28-percent rate, and taxpayers pay the higher of the AMT calculation or regular method of computing taxes. Over the years, bracket creep affects many taxpayers because their incomes, when not adjusted for inflation, put them in higher tax brackets and disqualify them for tax credits and other incentives like financial aid for their children's educations. Most programs and tax rates are now adjusted for inflation, but AMT only recently began doing so after the American Taxpayer Relief Act of 2012 was passed and signed into law.

Regardless of tax bracket, you could face taxation in a special bracket of 26 or 28 percent if your income makes you subject to AMT. It's important to consider whether this will happen when planning tax strategies to reduce your tax bite. If you don't, the most carefully planned deductions could backfire, but the news isn't all bad. People who expect higher incomes next year might want to accelerate income into years when they're only subject to a maximum 28-percent AMT rate. The best practices for dealing with AMT include calculating your tax under the regular method, determining your AMT exemption and trying to unwind AMT adjustments to evaluate your best tax strategies for that tax year.[7] As mentioned earlier, it might be advantageous to accelerate income to be taxed at 28 percent if you think you'll be in an even higher tax bracket the following year.

Capital Gains Taxes and Brackets

When you're figuring your taxes or deciding how to invest, there are two types of income: ordinary income that includes, wages, salaries, tips, bonuses, commissions, interest, dividends, business income, etc. and capital gains income that comes from selling stocks, real estate, bonds, mutual funds and other investments.

Tax brackets apply not only to regular income but also to capital gains, and recent increases in capital gains taxes make developing a proactive capital gains strategy more important than ever. However, there are many ways to realize a short- or long-term capital gain without generating too large a tax burden. In fact, with a minimum capital gains rate of zero and a maximum rate of 20 percent, long-term capital gains income could help to reduce your effective tax rate when a lot of your income comes from capital gains.[8]

Long-term capital gains tax rates are favorable when you compare them to other taxes like personal income tax brackets where the top rate is 39.6 percent. President Obama's American Taxpayer Relief Act eliminated capital gains taxes for low- and middle-income families since 2008 for families in the 10- and 15-percent tax brackets, and these benefits were made permanent when ATRA was signed into law on January 2, 2013. Under ATRA, people in the 25, 28-percent, 33-percent and 35-percent brackets pay just 15 percent capital gains taxes, and people in the 39.6-percent bracket pay 20 percent.

Another useful fact for middle-class investors that has great significance for building wealth and investing in real estate: Homeowners receive a $250,000 exemption ($500,000 for married couples) from capital gains realized on the sale of a primary home. These gains can be realized multiple times during a lifetime as long as the taxpaying homeowner complies with the rules that require the person to live in the home for two years out of every five years. This benefit has been around since 1997 when the law changed due to the Taxpayer Relief Act of 1997.[9] Stuck in long-term mortgages, younger home buyers might have never considered these implications when buying their first homes, and experienced buyers might not have noted the change in capital gains treatment. Many homeowners don't realize how much property values can appreciate over two or three decades. Cash-strapped couples could sell their homes, move to a low-maintenance apartment or buy a smaller, empty-nester home and realize up to $500,000 in tax-free capital gains.

Using Insurance Products to Avoid Higher Tax Brackets

Most life insurance doesn't reduce your taxes unless you own a business and buy life insurance to cover company officers. [10] However, you can buy policies as part of benefits packages for employees. Hiring relatives and establishing permanent life insurance policies for them build cash value, and the policyholders can withdraw cash without penalties before retirement for buying homes or financing college educations. Another valuable benefit of life insurance is that you can buy a permanent life insurance policy and earn cash value on a tax-deferred basis until you withdraw the money. Variable life policies offer plans that allow you to invest your policy's cash value in subaccounts that work like mutual funds.

Life insurance offers taxpayers ways to save for retirement, provide for children and heirs and protect income from higher tax bracket tax rates. Permanent or whole life insurance builds cash value and doesn't become taxable until you withdraw the cash. If you die, your heirs don't have to pay taxes on the death benefit. Other benefits of permanent insurance include:

• Employers can offer life insurance to employees of up to $50,000 of coverage and deduct the costs from taxes, which is especially valuable if you employ family members.
• If you transfer ownership of the policy, your heirs won’t have to include the death benefit in your estate./
• Investors can buy policies that cover the estate tax totals for their holdings so that their heirs don't have to pay them or sell off property or parts of the estate to pay the taxes.
• You can give family members cash of up to $14,000 each from your life insurance policy.
• Heirs don't have to pay federal or state taxes on insurance death benefits.
• Insurance proceeds also aren't used to calculate Social Security income.
• Life insurance can provide liquidity while an estate goes through probate.
• You can borrow against your insurance cash value and the death benefit without paying taxes on the loan, which gives you a way to withdraw your cash tax-free.

Using Tax Bracket Strategies Before and During Retirement

One of the easiest ways to shift income out of higher tax brackets is to invest money in an IRA, 401(k), 403(b) and most 457 plans because taxpayers can contribute up to $18,000 to the latter three and $5,500 to traditional IRAs.[11] Taxpayers who are 50 or older can contribute an additional $1,000 to IRAs, but some of these deductions are phased out for people who have higher incomes. Taking advantage of employer-sponsored plans and matching contributions to retirement accounts makes sound financial sense for anyone, and these retirement account contributions can significantly reduce the amount of income that's subject to higher tax bracket rates.

Roth Account Retirement Strategies

You might be in a higher tax bracket now but worry about taxes when you retire when your income is smaller and taxes could take a bigger effective percentage of the money that you need to maintain your family's lifestyle. If you can afford to do so, it's often better to invest in a Roth IRA, Roth 401(k) or Roth 403(b)

In Roth accounts, you don't get a tax deduction, but investing your after-tax dollars ensures that you can withdraw the money later without paying taxes or causing you to move to higher tax bracket during retirement years. You can continue to contribute to a Roth IRA for as long as you have earned income even after turning 70.

Small Business Strategies to Lower Your Tax Bracket Obligations

If you own a small business, tax brackets aren't the only thing that determines how much of your earnings you can actually spend. As a self-employed person, if you earn $100,000, you would pay the appropriate tax but also be liable for Social Security and Medicare taxes. However, if you incorporated as an S corporation and paid yourself a salary of $50,000 and a profit distribution of $50,000, you'd pay the same federal taxes on $100,000 but save more than $7,649 in Social Security and Medicare taxes. That's a prime example of shifting a substantial amount of taxable income to generate real-world tax savings.

Regardless of your tax bracket, you can save money by shifting substantial income out of the highest bracket and even out of lower brackets so that it's eventually taxed at a lower rate or earns tax-advantaged interest while you wait to withdraw the funds. The wealthiest people intimately understand tax brackets and how to make them work for their own interests, but you can do the same with proactive planning and knowledgeable advice from the right accountant or tax preparer specialist. The more income that you can shift, defer or invest in tax-advantaged products, the more that you can cut your effective tax rate. Brackets are just the beginning of the process and don't really determine what determined taxpayers might end up paying.

References:

• [1] Nancy Anderson, Will The 3.8 Percent Obama Care Surtax Apply To Me?, Forbes.com, October 25, 2012
• [2] Kyle Pomerleau, taxfoundation.org/sites/default/files/docs/TaxFoundation_FF486.pdf">2016 Tax Brackets, TaxFoundation.org, October 14, 2015
• [3] Staff article, How to invest tax efficiently: Find ways to help create a strategy that defers, manages, and reduces taxes, Fidelity.com, March 9, 2016
• [4] Robert E. Bertucelli, The benefits of captive insurance companies, The Journal of Accountancy, March 1, 2013
• [5] Henry Blodget, THE TRUTH ABOUT TAXES: Here's How High Today's Rates Really Are, Business Insider, July 12. 2011
• [6] Kay Bell, Beware the costly, complicated AMT, or alternative minimum tax, Bankrate.com, April 12, 2016
• [7] Michael Kitces, Evaluating Exposure To The Alternative Minimum Tax And Strategies To Reduce The AMT Bite, Kitces.com, April 9, 2014
• [8] Greg Iacurci, Don't fear capital gains tax, InvestmentNews.com, April 4, 2016
• [9] Kay Bell, Capital gains and your home sale, Bankrate.com, March 1, 2016
• [10] Staff, The tax advantages of permanent life insurance, New York Life, February 5, 2016
• [11] Emily Brandon, 401(k) and IRA Changes Coming in 2015, money.usnews.com, October 27, 2014