In the United States, we have a progressive income tax. This is a way to ensure the larger share of taxes are paid by those who can afford it the most. However, it’s not so simple as just taxing richer people more. Instead, your income is divided into tax brackets.
Understanding which bracket your income falls into can help you see how to minimize taxes. Sometimes, you can control when you receive income to make sure any gains fall into the lowest tax bracket possible.
What Is a Tax Bracket?
The income people earn is divided into brackets, and each bracket has its own marginal tax rate—the tax rate charged on that chunk of income. The lowest tax bracket is taxed at 10%, while the highest is taxed at 37%. Some people think this means the highest earners pay 37% of their total income. But it’s much more complicated than that.
Instead, imagine your income itself is divided into portions. The first $10,275 a single filer earns in a year falls into the first tax bracket. It is taxed at 10%. That’s right—there’s a portion of each person’s income which is taxed at the lowest rate, even if you’re a millionaire. Then the money you earn between $10,276 and $41,775 is taxed at 12%, and so on, until the only income taxed at the highest rate is the amount over $539,900 (for a single filer).
Effective Tax Rate
So nobody is paying 37% of their income on taxes. To find your effective tax rate—the total percentage of your income you pay on taxes—you can add the amounts you pay. Imagine you’re a single filer with a taxable income of $80,000 a year. On the first $10,275 of your income, you pay $1,028. On the next $31,499 of your income, you pay 12%, or $3,780. And on the last $38,224 you pay 22%, or $8,409.
Add all those together: $1,028 + 3,370 + 8,409 = $12,807, or 16% of $80,000. You have an effective tax rate of 16%.
Remember all of this is calculated on your taxable income. If you have deductions to include, this reduces your taxable income and may keep your income in lower brackets than it would be otherwise.
Tax Bracket Strategy
As you can see, there are sharp cutoffs in this system. When you exceed one bracket’s maximum, suddenly the rest of your income gets taxed at higher rates. This can result in the frustrating experience of a raise or windfall being much less helpful than you thought it would be.
One of the best ways to keep your income in lower brackets is taking deductions. There are no end of deductions you can claim, or you can take the standard deduction. Your accountant can help you decide which works best for your situation.
Sometimes, you might receive income in a large lump sum in a single year. For instance, if you sell a business for a million dollars, and the full sum comes in at once. This means the money is taxed at a much higher rate than it would be if you received it in smaller portions, keeping it in a lower bracket. A good strategy here is, whenever possible, arranging for payment to transfer over time, like one-quarter of the sale price over each of four years.
Likewise, any time you have a choice of receiving taxable income in a high-bracket year or a low-bracket year, choose to receive it in a low-bracket year. This is the strategy behind the Roth vs. traditional retirement account decision. If you’re in a low bracket now and hope to be in a higher bracket during retirement, you can use a Roth account to pay taxes now, when your income is low and the rate you will pay is less. But if you’re in your highest earning years and expect to earn less during retirement, you would use a traditional retirement account to defer taxes to later, when you will pay a lower rate.
Investing and Your Tax Bracket
Investments earn income at predictable times. Most investments are taxed when you sell them, realizing a capital gain. So you can make strategic decisions about when to realize these gains. If you need to make a large sale, realizing a large capital gain, it can be a good year to also unload some bad investments that will realize a loss. This helps to offset your gains and keep your taxable income lower.
Withdrawals from retirement accounts are taxable. You don’t have a choice about taking required minimum distributions (RMDs) during your retirement. But if your income is high this year, avoid taking more out than you need to.
Some of your income is not in your control. For instance, mutual fund distributions usually happen annually, and you will need to pay taxes on this income. By keeping an eye on the projected distributions, you can decide if you want to sell the fund now or accept the distribution when it happens. Plus, you can start looking for ways to offset this income if it’s large.
Help Managing Your Tax Bracket
As you can see, your tax situation can get very complicated, especially if you invest or own a business. And the decisions that affect your tax bracket can come up long before tax time. For professional help controlling your tax burden, you need a financial advisor. Contact us today to find the right one for you.