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Tax Brackets

How do the tax brackets work?

If you earn enough money to enter a higher tax bracket, do you take home less than if you stayed in a lower bracket?

While this is a common question I answer, it is absolute fiction. Unfortunately our tax code is so complex that we have trouble wrapping our minds around this concept. The United States uses a progressive tax system, which means different portions of your income are taxed at different rates. Progressive rates are based on the concept that high-income taxpayers can afford to pay a higher tax rate.

Tax brackets are calculated using taxable income. Taxable income is your income less adjustments and itemized (or standard) deductions. This figure is then used in the tax table to determine your tax due. The tax bracket, generally speaking, is the tax rate you pay on your highest dollar of taxable income. Each dollar you earn only affects the tax rate on additional income. It does not change the tax rate you pay on dollars in lower tax brackets.

For example, if you are single with taxable income of $40,000, a portion of your income is taxed at 10%, another portion is taxed at 15%, and the remaining is then taxed at 25%. While this taxpayer is technically in the 25% tax bracket, not all their income is taxed at 25%. The effective tax rate (the actual paid or average) in this example is only 14%.

Jake Wisdom