Understanding Tax Brackets
Understanding tax brackets is critical for proper financial planning. Failure to understand tax brackets could result in thousands of dollars in unnecessary taxes paid. On the other hand, knowing your tax bracket ensures you have the information you need to make sound financial choices as your wealth grows.
We provided an overview of income taxes in our previous post. Go back and check it out for a high-level primer on income, deductions, credits, and total tax owed.
In this post, we’ll talk about tax brackets, why they matter, and strategies you can implement so you don’t pay more tax than you should.
The Progressive Tax System
The United States utilizes a progressive tax system as the basis for establishing how much income tax everyone owes.
This means as your income increases, the percentage of the income you owe as tax also increases. The percentages that are owed as income tax are set in tax brackets.
These brackets tax all income that falls within them at a certain rate until the income level moves the payer into the next bracket. That next bracket of income is taxed at that rate until the next, higher bracket is reached, and so on.
For 2023 the federal income tax brackets are as follows:
Tax Rate | Income Level Single | Income Level Married Filing Jointly | Income Level Married Filing Separately | Income Level Head of Household |
10% | $0 – $11,000 | $0 – $22,000 | $0 – $11,000 | $0 – $15,700 |
12% | $11,000 – $44,725 | $22,000 – $89,450 | $11,000 – $44,725 | $15,700 – $59,850 |
22% | $44,725 – $95,375 | $89,450 – $190,750 | $44,725 – $95,375 | $59,850 – $95,350 |
24% | $95,375 – $182,100 | $190,750 – $364,200 | $95,375 – $182,100 | $95,350 – $182,100 |
32% | $182,100 – $231,250 | $364,200 – $462,500 | $182,100 – $231,250 | $182,100 – $231,250 |
35% | $231,250 – $578,125 | $462,500 – $693,750 | $231,250 – $346,875 | $231,250 – $578,100 |
37% | $578,125 or more | $693,750 or more | $346,875 or more | $578,100 or more |
I want to point out something that confused me the first few times I completed an income tax return.
Even though the cumulative total of your income for a given year may place you in a certain tax bracket, this does not mean that all the income you made that year is taxed at that rate.
Instead, the income falling in each tax bracket is taxed at that level.
This means the actual percentage of your income that you pay as tax will always be lower than the actual tax bracket you fall into.
For example, let’s assume Bennie Bracket is single and had a taxable income of $60,000 in 2023. This means the first $11,000 Bennie made is taxed at 10% (that’s $1,100.00).
The next $33,725 which falls between $11,000 and $44,725 is taxed at 12% (that’s $4,047.00).
Finally, the remaining $15,275 ($60,000 – $33,725 – $11,000) will be taxed at 22% (that’s $3,360.50).
In this scenario, the total tax owed would be $8,507.50 ($1,100.00 + $4,047.00 + $3,360.50) which is actually 14.18% of Bennie’s taxable income.
(For perspective, Bennie would have owed $8,817.10 in 2022, but the tax brackets shift up and get larger each year. This means, assuming taxable income remains constant, effective tax rates will fall.)
We don’t know Bennie’s gross income, but in all likelihood, Bennie took the standard deduction of $13,850.
If we add that back to his taxable income, Bennie paid 11.52% of his $73,850 gross income.
This 11.52% average of Bennie’s actual tax paid as compared to his gross income is known as the Effective Tax Rate.
The top tax bracket Bennie falls into is known as his Marginal Tax Rate (22% in this case). We’ll talk more about this important data point later.
The Progressive Tax Tanks
When considering tax brackets, it’s helpful for me to think about them as a series of tanks.
The first tank has a capacity of $22,000 for those who are married and filing jointly. Everything that fits into this tank is taxed at 10%.
Once it reaches capacity, the spillover flows into the 12% tank. This tank is a little bigger and can hold up to an additional $67,450 which is a cumulative total of $89,450 between both tanks.
After the 12% tank fills the excess spills over into the 22% tank.
This tank is bigger still and can hold another $101,300 (up to $190,750 total now) before it spills into the 24% tank.
And on the tanks fill until you reach the bottomless 37% tank where every dollar from here on out is taxed at that rate.
The 12-22 Jump
Next, I want to highlight an important feature of the tax brackets we currently have.
There are a couple of income thresholds where money begins to be taxed at a much higher rate than the tax bracket before.
For example, if your income leaves you close to the 12% and 22% tax brackets, you can save 10% of every dollar you can keep in that 12% tax bracket.
This is pretty important to note because it’s basically a guaranteed savings of 10% on that money.
That’s right at the average rate of return for the S&P500 over the years, but without any of the risk.
The Portions of your money that you can save from taxes are guaranteed savings and aren’t subject to hoping the markets have a decent year.
Ten percent is a great return and effort should be made to preserve it.
There’s another steep increase between the 24% and 32% tax brackets which presents an 8% savings opportunity.
With that said, making so much money that you’re in a higher bracket isn’t all bad either. It’s not like you should turn down income to stay in a lower bracket.
But, if your income leaves you close to these bracket boundaries, you might consider ways to keep your income down just a bit to take advantage of your proximity to much lower tax brackets. We’ll talk more about these tax bracket turning points below.
Where do Capital Gains and Dividend income go?
One item we should discuss is tax brackets for capital gains and dividend income. Those brackets are listed below:
DIVIDENDS 2023 | ||||
Tax Rate | Income Level Single | Income Level Married Filing Jointly | Income Level Married Filing Separately | Income Level Head of Household |
0% | $0 – $44,625 | $0 – $89,250 | $0 – $44,625 | $0 – $59,750 |
15% | $44,625 – $492,300 | $89,250 – $553,850 | $44,625 – $276,900 | $59,750 -$523,050 |
20% | $492,300 or more | $553,850 or more | $276,9000 or more | $523,050 or more |
CAPITAL GAINS 2023 | ||||
Tax Rate | Income Level Single | Income Level Married Filing Jointly | Income Level Married Filing Separately | Income Level Head of Household |
0% | $0 – $44,625 | $0 – $89,250 | $0 – $44,625 | $0 – $59,750 |
15% | $44,625 – $492,300 | $89,250 – $553,850 | $44,625 – $276,900 | $59,750 -$523,050 |
20% | $492,300 or more | $553,850 or more | $276,9000 or more | $523,050 or more |
A dividend is a share of earnings paid to shareholders of a company.
This payment is usually made on a quarterly basis and is taxable unless the asset is held in a tax-deferred or Roth-type account.
Capital gains are the appreciated value of an asset over its base or purchase price.
For example, if you bought a share of Apple stock for $100 and sold it over a year later for $120, your capital gain is $20. The $20 gain would be subject to capital gains tax depending on your bracket.
You will probably quickly notice the tax brackets for capital gains and dividends are much more favorable than those for standard income.
This incentivizes owners of capital assets to hold onto them for at least a year as short-term capital gains (those realized after less than one year of ownership) are taxed at normal income tax rates.
Short-term capital gains have the ability to push your income up into higher tax brackets.
Long-term capital gains (again, those gains on assets owned more than one year) are considered a separate category of taxable income.
Capital gains and dividends are calculated “on top” of or after wage income is tabulated and both are calculated as part of one’s adjusted gross income (AGI)
Tax Loss Harvesting
One feature of capital gains income is the ability of capital losses to offset gains in a given tax year.
For example, if you sold the Apple stock we mentioned above for $80 instead of $120, you’d have a capital loss of $20 which can be used to cancel out or offset any realized gains of the same amount.
Furthermore, you can claim up to $3,000 in capital losses each tax year to reduce your taxable income. Any excess losses can be rolled over to subsequent tax years indefinitely.
This process is known as tax loss harvesting and is a useful strategy for those of you with taxable investment accounts having a rough year.
If you own securities that pay out regular dividends, you should hold those in a tax-advantaged space to avoid the regular tax liability they create every time a dividend is distributed to shareholders.
Why you need to know your tax brackets
Back at the start of this post, we defined the marginal tax rate as the amount of tax you pay for income earned in your highest bracket.
So, if you are in the 22% bracket, that means your marginal tax rate is 22% and every dollar you make up to the next bracket will be taxed at 22%.
It’s important to know this because understanding your marginal tax rate is a primary factor in how you decide to invest your retirement savings.
More specifically, marginal tax rates help us determine if we should invest in Roth or Traditional vehicles.
We briefly hit on the Roth vs Traditional debate in Milestone 5 of the Next Dollar Roadmap.
In that post, we illustrated how the choice depends on what your income tax bracket is now versus what you expect it to be when you withdraw the funds.
If you suspect that your marginal tax rate is higher now, you should elect traditional or pre-tax accounts.
If you think your marginal tax rate will be higher in retirement, it’s better to pay the tax now and save in Roth accounts.
You see, you can’t make this decision if you don’t know your marginal tax rate.
A second reason to keep an eye on your marginal tax rate is for optimizing tax planning for retirement.
Even if you have invested primarily in pretax or traditional retirement accounts, you can convert IRA funds from traditional to Roth at any time. You can’t go the other direction, but why would you want to?
If you have traditional 401(k) savings, it can be converted too but you’ll need to roll it into an IRA first.
Why would you want to do this? The primary motive is usually to avoid required minimum distributions or RMDs.
When you turn 72, 73, or 75 (depending on when you were born) you have to begin taking RMDs on your 401(k) or traditional IRA accounts, whether you need the money or not.
The reason is these savings have been sitting for years without generating any tax for Uncle Sam. It’s time for him to collect his due.
If you convert these dollars to a Roth, those funds get to avoid RMDs. However, you have to pay income tax on the amount you convert.
If you are converting in a low tax bracket, that’s obviously better than converting at a high one.
Knowing your marginal tax rate allows you to plan those conversions effectively so you don’t pay more than you’d like in taxes.
Let’s look at an example:
Rachel Retiree
Suppose Rachel Retiree is 60 years old and has an annual taxable income of $36,000. Rachel is single and her annual expenses are only $30,000, so she doesn’t need the $350,000 she has saved in her traditional IRA.
In seven years, however, the IRS will begin forcing Rachel to withdraw RMDs. In the first year, Rachel will have to withdraw 3.96% out of her IRA which is $13,860 she doesn’t actually need.
Instead, Rachel would prefer to leave as much as she can as an inheritance to her niece.
Rachel’s friend advises her to begin converting her traditional IRA to a Roth IRA because the money can grow tax-free during her lifetime and can be left to her niece without triggering any additional taxes.
Because Rachel knows the 12% tax bracket goes up to $44,725, she calculates that she can convert up to another $8,725 annually from her traditional IRA to a Roth IRA.
After twelve years, she has converted $104,700 from the Traditional IRA to a Roth. Her traditional IRA continued to grow and she still has around $320,000 in the account from which she will have to take RMDs (About $12,800 in the first year).
In summary, as a result of her conversion efforts, Rachel will still have to take an RMD but also has $104,700 now growing tax-free in a Roth IRA which is not subject to RMDs that trigger more income tax.
Of course, if Rachel had started earlier or if she was willing to convert up to the top of the next bracket ($95,375) she could convert even more of her traditional funds to the Roth.
I’d like to point out that in my oversimplified example, I have Rachel converting the same amount every year. Tax brackets are changed annually, so she would actually be able to convert much more than this over the 12-year conversion period.
The history of income tax rates and the future of income tax in 2026
Income tax brackets over the years have varied greatly. Over time, the highest tax brackets have had the tendency to drop.
In 1944-1945, the highest bracket was taxed at 94%!!! Desperate times, desperate measures I suppose.
In 2018, tax rates fell to what I’d characterize as some of the lowest rates in modern history, although rates for low to middle-class incomes have actually been relatively stable.
The greatest fluctuations occur at the highest brackets and will likely only increase from where we are at this point in 2022 and looking into 2023.
In fact, tax brackets across the board will revert to their 2017 levels in 2026. The actual brackets will have to be adjusted for inflation, but in 2017 they looked like this:
INCOME TAX BRACKETS 2017 | ||||
Tax Rate | Income Level Single | Income Level Married Filing Jointly | Income Level Married Filing Separately | Income Level Head of Household |
10% | $0 – $9,325 | $0 – $18,650 | $0 – $9,325 | $0 – $13,350 |
15% | $9,326 – $37,950 | $18,650 – $75,900 | $9,326 – $37,950 | $13,351 – $50,800 |
25% | $37,951 – $91,900 | $75,901 – $153,100 | $37,951 – $76,550 | $50,801 – $131,200 |
28% | $91,901 – $191,650 | $153,101 – $233,350 | $76,551 – $116,675 | $131,201 – $212,500 |
33% | $191,651 – $416,700 | $233,351 – $416,701 | $116,676 – $208,350 | $212,501 – $416,700 |
35% | $416,701 – $418,400 | $416,701 – $470,700 | $208,351 – $235,350 | $416,701 – $444,500 |
39.6% | $418,401 or more | $470,700 or more | $235,351 or more | $444,501 or more |
Not a huge difference, but something to keep in mind as 2026 approaches. Of course, many things can change between now and then, so don’t bet the farm on these old brackets.
Conclusion
Taxes aren’t fun; they’re just not.
But if you want to exhibit full control over your finances you need to understand how they work and how they impact you personally.
