What Are Tax Brackets, and How Do They Work?

Understanding income tax brackets can be a difficult task for many taxpayers. But tax brackets are what determine how much taxable income taxpayers need to pay to the Internal Revenue Service each year. That’s why it’s important for everyone to learn about tax brackets, how they actually work, and which tax bracket they’re in, whether they’re married or single.

How tax brackets work

It’s a common misconception that being in a certain tax bracket means all your income gets taxed at that rate. If this were true, that would mean that if you made $100,000 and were in the 24% tax bracket, you’d pay about $25,000 in taxes.

That’s NOT how taxes work. Instead, tax rates are marginal, which means your income is taxed at different rates. Your income is divided into different levels — or brackets — so that each dollar of income is only taxed at the rate of the bracket it falls into.

It might help to think of tax brackets like a row of buckets. Each bucket holds a certain amount of money and is taxed at a certain rate. Every year, the government adjusts the rates and sizes of each bucket. For 2021, the seven tax brackets were 10%, 12%, 22%, 24%, 32%, 35% and 37%.

It’s important to note here that your tax bracket depends on your taxable income (how much you make a year) and your filing status, which we’ll explain in more detail later. Generally, as you move up the pay scale, you also move up the tax scale.

So let’s say you’re single and you make $100,000. The first bucket — or income tax bracket — holds $9,950 and is taxed at 10%. In the next bucket, you pay 12% on $40,525, and you pay 22% on $49,525, which would be the remainder of your $100,000 income.

The rate of your highest tax bracket, which in the above example is the 22% bucket, is called your marginal tax rate. But also in the example above, you see that the income of a single person making $100,000 actually falls into multiple tax brackets. So the overall rate you pay is actually less than the marginal tax rate. The percentage you actually pay in taxes is called your effective tax rate.

Keep in mind that not all your income is taxed. There are exemptions and deductions that can reduce the amount that’s taxable. Contributions to your 401(k) or IRA can reduce your taxable income, as can contributions to your health savings account, or HSA. In addition, if you have children, you may be eligible for a child tax credit.

Talk with your tax professional about contributions that can help reduce your taxable income.

Understanding what tax bracket you’re in

In the above example, we used a single person. The single tax bracket is just one of the five filing statuses; the other four are married filing jointly, married filing separately, head of household, and qualifying widow or widower with dependent child/children. But how do you know which filing status to choose in a given year?

The IRS offers guidance on that:
Single filing status generally applies if you’re not married, divorced or legally separated according to state law.

Married filing jointly allows a married couple to file a return together using this status. If your spouse died during 2021, you usually may file a joint return for that year.

Married filing separately allows a married couple to file their returns separately.

Head of household status generally applies if you’re not married and you’ve paid more than half the cost of maintaining a home for yourself and a qualifying person.

Qualifying widow or widower with dependent child status applies if your spouse died during 2020 or 2021, you have a dependent child and you meet certain other conditions.

The IRS says your marital status on the last day of the year is your marital status for the entire year, and if more than one filing status fits you, choose the one that allows you to pay the lowest taxes.

For more informational articles on tax related topics, such as how to set up tax withholding, 7 ways to make your tax refund count, how to save money on your taxes, and smart ways to spend your tax refund, visit soundadvice.bankatfirstnational.com or consult your tax advisor. First National Bank and Trust’s financial experts are available to you in any of our 16 full-service locations you’ll find throughout southern Wisconsin and northern Illinois. Come in to visit with us, or contact us to learn more.