Whether we like or not, taxes are an unavoidable part of life. While many of us are familiar with the concept of income taxes, the specifics can often be confusing. One of the key components of how taxes are applied to your income is the tax bracket system. Understanding how tax brackets work is crucial for managing your income, maximizing deductions, and optimizing your tax liability.
In this article, we’ll explore what tax brackets are, how they affect your income, and how you can leverage this knowledge to make informed financial decisions.
What Are Tax Brackets?
A tax bracket is essentially a range of income levels that are taxed at a specific rate. The United States uses a progressive tax system, which means that as your income increases, you are taxed at higher rates for the portions of your income that fall within different tax brackets. However, it’s important to note that you’re not taxed at the higher rate for your entire income. Instead, only the portion of your income that falls into each bracket is taxed at that rate.
For example, if you earn $60,000 a year and your tax bracket is 22%, only the portion of your income that exceeds the lower tax bracket’s limit is taxed at 22%. The income in lower brackets is taxed at lower rates.
How Tax Brackets Work
The IRS provides tax brackets annually, and these are divided into seven income ranges. Each tax bracket has its own tax rate, which increases as your income rises. The key takeaway here is that the U.S. tax system is progressive. This means that higher levels of income are taxed at progressively higher rates, but the entire income isn’t taxed at the highest rate. Instead, income is divided into chunks, and each chunk is taxed at the rate corresponding to its tax bracket.
How Do Deductions and Credits Affect Your Tax Bracket?
Your taxable income determines which tax bracket you fall into. However, you can reduce your taxable income by using deductions and credits.
- Deductions: These reduce your overall taxable income, which can potentially move you into a lower tax bracket. For example, if your taxable income is $60,000, but you have $10,000 in deductions (such as mortgage interest or retirement plan contributions), your taxable income is reduced to $50,000. This could lower the amount of tax you owe, especially if it moves you into a lower tax bracket.
- Credits: Tax credits directly reduce your tax liability. A tax credit is not tied to your income; it is a fixed amount that directly reduces the taxes you owe, making it even more valuable than a deduction.
The Impact of Tax Brackets on Your Financial Planning
Now that you have a better understanding of how tax brackets work, let’s discuss how this knowledge can impact your financial planning and tax strategy.
1. Strategic Income Management
If you’re close to crossing into a higher tax bracket, you might want to explore ways to manage your income to avoid paying higher taxes. For example:
- Defer income: If you’re self-employed or have control over when you receive income (such as through bonuses or commissions), consider deferring part of your income to the following year to stay in a lower tax bracket.
- Bunch deductions: You can also consider bunching deductions (like medical expenses, charitable contributions, or property taxes) in a single year to exceed the standard deduction threshold and take advantage of itemizing deductions.
2. Roth vs. Traditional Retirement Accounts
When planning for retirement, understanding tax brackets can help you decide whether to contribute to traditional retirement accounts (like a 401(k)) or Roth retirement accounts (like a Roth IRA). If you’re in a higher tax bracket now, contributing to a traditional 401(k) may allow you to lower your taxable income for the year, deferring taxes until you withdraw the funds in retirement. Alternatively, contributing to a Roth IRA allows you to pay taxes now and withdraw funds tax-free in retirement, which may be advantageous if you expect to be in a higher tax bracket later in life.
3. Capital Gains and Investments
Understanding tax brackets is also critical when managing investments. Long-term capital gains (profits from the sale of assets held for more than a year) are taxed at favorable rates, which depend on your income tax bracket. The lower your income, the lower your capital gains tax rate. Being mindful of your total taxable income can help you manage how and when you sell investments to minimize capital gains taxes.
Key Takeaways:
- Tax brackets are ranges of income taxed at specific rates. The U.S. uses a progressive tax system, meaning that higher portions of your income are taxed at higher rates.
- Only the portion of your income that falls into each tax bracket is taxed at that rate, not your entire income.
- You can manage your tax bracket by utilizing deductions, credits, and strategic income management.
- Tax planning can also help you decide whether to prioritize contributing to tax-deferred or tax-free retirement accounts based on your current and expected future tax brackets.
Understanding tax brackets is a crucial part of financial literacy. By knowing how the tax system applies to your income, you can better plan your finances, optimize your deductions, and manage your overall tax liability. It’s important to remember that the tax bracket system is progressive, and only the income in each specific range is taxed at that rate—not your entire income.
By incorporating tax strategies into your financial plan, you can make smarter decisions about your retirement, investments, and income management. Whether you’re maximizing deductions, contributing to the right retirement accounts, or managing your investments, understanding your tax bracket is an essential step toward achieving your financial goals.
The commentary on this blog reflects the personal opinions, viewpoints and analyses of the author, Katherine Sullivan, and should not be regarded as a description of advisory services provided by Foundations Investment Advisors, LLC (“Foundations”), or performance returns of any Foundations client. The views reflected in the commentary are subject to change at any time without notice. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security, or any security. Foundations manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary.