What Tax Bracket Are You In and Why Does It Matter?

It’s that season again and I don’t mean Spring… it’s tax season. Whether you do a 1040EZ or need a team of accountants to make sense of your financial life, everyone has to do it.  So, what is your tax bracket and why does it matter? Your tax bracket is the highest marginal rate you will pay on any income. What??? Let’s take a look.

Adjusted gross income means income after you’ve taken all the credits and deductions you’re eligible for and added up all you sources of income including but not limited to salaries, bonuses, consulting, and benefits, (see IRS for more details on income sources) etc.  Remember, your tax bracket will be different if you’re married filing jointly, married filing separately, individual or head of household so make sure you look at the right brackets.

Remember I said, “Your tax bracket is the highest marginal rate (percentage) you will pay on any income?”  Well, some of your income is taxed at a lower rate. So here’s what I mean:

The Math for Married Filing Jointly:

Adjusted Gross Income (AGI) = $125,000

  • The first $17,850 is taxed at 10%
  • From $17,851 to $72,500 is taxed at 15%
  • From $72,501 to $125,000 (your income) is taxed at 25%

$17,850 * 10% = $1,785 in tax

$72,500 – $17,850 = $54,650 * 15% = $8,197.50 in tax

$125,000 (your income) – $72,500 = $52,500 is taxed at 25% = $13,125

  • Total tax bill = $1,785 + $8,197.50 + $13,125 = $23,107.50
  • Your effective tax = $23,107.50/$125,000 = 18.5%
  • Your tax bracket: $125,000 falls between $72,501 and $146,400 = 25% bracket
  • Your tax bracket is also called your marginal rate

Why do you care? Well, knowing is always better when it comes to your finances. When you know you can adjust your withholding (if you work for someone else) so that you get a big refund or so that you don’t have to pay on April 15th. You can adjust your savings and spending if you know how much tax you will owe the IRS in April (remember, you won’t know exactly until you complete your tax forms, but you will know approximately).  Some people love a good refund check while others want the cash in their weekly or bi-weekly paycheck.

Also, if you work for yourself and can take jobs when you want to, you may decide to put off a job that might put you into a higher tax bracket for the year.   Just like working for yourself, you may have other sources of income that can be spread over years to lower your tax bracket (or not make you go up a tax bracket) such as from the sale of investments.