How those tax brackets work

I believe that there is a huge misconception on how our current tax bracket system works.  I get calls from clients frequently asking me to see how much more money they can, for example, withdraw from a retirement account this year before they are pushed into the next tax bracket.  The common misunderstanding is that once you are pushed into the next bracket, ALL of your income is going to be taxed at that higher rate.  This is not the case though.

The first thing that should be understood is that there are differences between your “gross income” (i.e. the amount on your w-2), your “Adjusted Gross Income” (i.e. gross income less certain deductions), and your “Taxable Income” (i.e. your Adjusted Gross Income less your itemized or standard deduction and exemptions).  Your taxable income is what determines where you fall on the tax bracket spectrum.  It is a much more difficult figure to come up with than most people perceive.

In fact, many taxpayers’ income is actually taxed at multiple rates instead of just one.  For example, if you were married and filing a joint return with $70,000 of taxable income, the first $17,400 would be taxed at 10% and the remainder at 15%.  The misconception is clearly seen if, for example, your taxable income was $71,000—while you would be considered to be in the 25% tax bracket, less than 1% of your taxable income would actually be taxed at the 25% rate.  The majority of your income would be taxed at the 10 and 15% rates.

2012 Tax Brackets

Tax   Bracket

Married   Filing Jointly

Single

10% Bracket $0 – $17,400 $0 – $8,700
15% Bracket $17,400 – $70,700 $8,700 – $35,350
25% Bracket $70,700 – $142,700 $35,350 – $85,650
28% Bracket $142,700 – $217,450 $85,650 – $178,650
33% Bracket $217,450 – $388,350 $178,650 – $388,350
35% Bracket Over $388,350 Over $388,350

 

While it is very important to be aware of where your income stands during the year, you can put your mind at ease knowing that an extra $100 or $1000 is not going to have the drastic tax effects that you may once have thought.

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