How Do United States Federal Tax Brackets Work?

June 18, 2018

  • The United States uses a progressive income tax system which means the more you make, the more you pay as a percentage of your income.
  • Deductions wipe out most income tax liability for lower income individuals and families. Deductions were increased for 2018 and beyond.
I recently consulted with an individual who received a significant financial windfall from her employer. She is a single woman with no children and makes about $40,000 a year. Her employer gave her a $100,000 bonus early in the year. I met her a few months later and she had not yet cashed the check. When I asked her why she said she was worried that the government was going to take it all. Her accounted told her she would end up paying over 70% of it in taxes and she came to me asking for help.

First thing I did, of course, was recommend a new account. The second thing I did was explain to her how tax brackets work and, although I’m not a tax advisor, showed her what I though her real tax liability was going to be.

U.S. Income Taxes Are Progressive

U.S. tax brackets for 2018

In the United States, we have a progressive income tax system, which means the more you make, the more you pay. See the chart above for both the single and married tax brackets for 2018. A single person making up to $9,525 will be in the 10% tax bracket. If she has a jump in income, up to $38,700, she will be subject to the 12% tax bracket. If her income goes even higher up to $82,500, she will be in the 22% tax bracket.

Tax brackets are progressive

Where the confusion lies is in the tax’s progressive nature. Just because you are in the 22% tax bracket, does mean you pay 22% of what you make. At $82,500, the first $9,525 is still only taxed at 10%. The next $29,175 ($38,700 minus the first $9,525) is taxed at 12%. Only the remaining balance above $38,700, $82,500 minus $38,700, or the top $43,800 is taxed at 22%.

For a single person making $82,500, she would end up paying an effective tax rate of 17%. The calculation is done in three steps; 1) $9,525 at 10% equals $953, 2) $29,175 at 12% equals $2,501, 3) $43,800 at 22% equals $9,636. Add all three up and you get $14,090 or 17% of $82,500.

You get deductions as well

Deductions are adjustments made to your taxable income and are given to individuals or families who are engaging in activities that the government wants to encourage. Spend money on these things, and you don’t have to pay taxes on those dollars. For example, if you take $1,000 per year out of your pay and contribute that money to a 401(k) or other retirement plan, you don’t need to pay taxes on that $1,000. In the example of an individual making $82,500, you would only subject $81,500 to the tax brackets.

The major tax deductions include; contributions to a retirement plan, contributions to a flex spending plan, health insurance premiums, some medical and dental expanse, taxes you pay to a state or local government, mortgage interest, charitable donations, and some job expenses. Each of these come with limitations and you can read more about them in other articles on this blog.

The major deduction, though, for everyone, no matter their financial situation or income, is the standard deduction. For a single person it is $12,000 and a married couple it is $24,000.

Assuming a standard deduction, go back to the $82,500 example above. After subtracting the $12,000 standard deduction, only $72,500 is subject to tax. The first $9,525 at 10% equals $953. The next $29,175 ($37,700 minus $9,525) is taxed at 12% which equals $3,501. The remaining $31,800 ($70,500 minus $38,700) is taxed at the maximum rate of 22%. That equals $11,450 in tax, dropping the effective rate from 17% to 13.9%.

Higher Income Leads To Higher Tax Rate

The real word example

Look now at the example of the single woman getting a $100,000 windfall from her employer. Her “accountant” told her she would pay 70%. I have no idea where that came from. She is single, no children, and does not have a mortgage. Therefore, in a normal 2018, on $40,000, she would take the standard deduction of $12,000. That means $28,000 would be taxable assuming no contributions to retirement or flex plans. $28,000 puts her in the 12% tax bracket, but the first $9,525 is only at 10%. Her tax liability would be $3,170 or an effective rate of 7.92%.

With the $100,000 of additional income she now will claim $140,000 income for the year, she would still be able to take the $12,000 standard deduction bringing her taxable down to $128,000 pushing her into the 24% tax brackets. Calculating through the 10%, 12%, 22% and 24% brackets, she would end up paying $25,010 in total Federal tax, or 17.86% or her total income for the year.

Higher Income Means Higher Tax Rate

The Bottom Line

Rounded to the nearest percent, the sample client will pay about 18% in Federal tax but would also be subject to State income tax. The highest marginal State income tax is California at 13.3%, but their taxes are progressive as well and starts at only 1%. $140,000 would put a single filer at 10.3%. Many States, though, such as Texas, Nevada, Washington, and Florida have no State income tax, so her total tax liability would depend on the State she lives in. I did a calculation for her State and it came resulted in an effective rate of 5%. 18% plus 5% is a total tax liability of 23%, no where near the 70% she thought she was going to need to pay.