Many people who begin earning more income hear about the idea of tax brackets. You don't, they may warn you, want to end up in a higher tax bracket. But what does this really mean? And how can you ensure that you are doing all you can to minimize your tax bill? Here's what you need to know.
What Are Tax Brackets?
Because the United States uses a progressive tax system, income is subjected to a ladder of tax rates. These rates begin low — as little as 10% — and then increase to larger percentages as you earn more taxable income. The different percentages are called tax brackets.
Is All Income Taxed In the Same Bracket?
If you are told you are in the 22% tax bracket, does this mean that all your income is taxed at 22%? In fact, it is not. Income is first taxed at lower rates up to published thresholds. Then, the next amount is taxed at the next rate up, and so forth. So, for instance, the first $9,875 you earn may be taxed at 10% tax (in 2020). The next $30,250 may be taxed at 12%. If you earn more, this progression will continue.
As a result, taxpayers should understand their tax bracket as well as their effective tax rate. The effective tax rate adds up all their income and divides the actual taxes paid to determine what their overall percentage is. In the above scenario, the effective tax rate for the year is closer to 11.5% ($9,875 at 10% and $30,250 at 12%).
How Can You Plan for Tax Brackets?
Tax planning for brackets generally involves avoiding the next threshold. If income over $85,526 will be taxed at 24%, for instance, you might use deductions or delay the receipt of some income to avoid reaching this threshold. If you put off a bonus until the new year in this scenario, that bonus will be taxed at the low rate once again as the annual process starts over.
If you can't avoid reaching a threshold, you should at least plan for the additional taxes. A wage earner's withholding may automatically adjust to try to account for higher taxation at higher incomes, but an independent contractor or business owner may need to reassess quarterly payments to make sure they don't end up with a big tax bill.
Where Should You Start?
Tax planning, including the avoidance of higher percentage rates of tax, should be done as soon as possible. This way, you have the chance to make more changes that will lower your taxes throughout the year. Start by meeting with an experienced accountant or tax preparation service in your state today.