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Few things are harder to understand than income taxes. You might think that it would be the simplest thing in the world to figure out what tax bracket you're in, but as it turns out, it's a lot more complicated than you'd think. Below, though, I'll give you some simple tips to answer the question “What tax bracket am I in?” and to find out what you can do to get into a lower bracket.
Keeping track of the numbers
Every year, the IRS releases income tax brackets. Currently, there are six different brackets that apply to various income levels depending on your filing status. The lowest bracket of 10% applies to taxable income up to $8,700 for single filers and $17,400 for joint filers, above which the 15% tax bracket kicks in. Brackets gradually rise until you get to the highest bracket at 35%, which kicks in for most taxpayers above $388,350.
Your first instinct might therefore be to assume that all you have to do is add up all your income and then figure out where on the IRS table you end up. In an ideal world, that would be all you'd need to figure out your tax bracket.
But the key to understanding tax brackets is that they work from taxable income, which is a legal term that refers to a very specific calculation. In order to come up with your taxable income, you take your total gross income, make any adjustments allowed, and then reduce it by a certain amount for personal exemptions as well as either a standard deduction or itemized deductions.
All of that can get extremely complicated and is impossible to generalize for every situation. But taking a simple case involving a single filer with no dependents, you'd be entitled to one personal exemption of $3,800 and a standard deduction of $5,950, adding up to $9,750. So assuming that you have no further adjustments to income, you would take your total wages, interest, dividends, and any other income and then subtract $9,750. That would then give you the taxable income amount to plug into the table.
Why it doesn't matter as much as you think
Before you panic about what tax bracket you're in, take a minute to make sure you're not making a common mistake. Many people believe that once you move into a higher tax bracket, all of your income gets taxed at that higher rate. As a result, you can come up with a nightmare scenario where if you have taxable income of $8,700, you'd owe $870 in tax; but if you earn $8,800, the 15% bracket would apply to the whole thing and you'd suddenly owe $1,320 -- $450 more in tax for just an extra $100 in earnings.
In reality, though, tax brackets don't work this way. Rather, the tax bracket applies only to the amount of income that falls within that higher bracket. So using the example above, the person earning $8,800 would pay 15% tax on the $100 in that bracket but would still get the full benefit of the 10% bracket for the first $8,700.
Get into a lower bracket
Nevertheless, there are situations where being in a lower tax bracket can be advantageous. Here are some ways you can move yourself into a lower bracket:
- Contribute to retirement accounts. If you're eligible to deduct IRA contributions, they can reduce your taxable income. Similarly, 401(k) contributions at work lower your income and can take you into a lower bracket.
- Maximize deductions. If you itemize deductions, having more to deduct also reduces your taxable income.
- Change your filing status. Most people would agree that taxes shouldn't be the primary motivation for getting married or having children, but for some taxpayers, filing jointly or as head of household can result in a lower tax bill, because those filing statuses have wider brackets, requiring more income before higher tax rates kick in.
- Pick tax-efficient investments. Certain investments can help you reduce your taxable income. For instance, master limited partnerships Kinder Morgan Energy Partners (NYSE: KMP ) , Enterprise Products Partners (NYSE: EPD ) , and Energy Transfer Partners (NYSE: ETP ) all make distributions that look like dividends, but some of them are treated as return of capital and therefore not taxed immediately. Similarly, iShares S&P Nat'l AMT-Free Muni ETF (NYSEMKT: MUB ) invests in municipal bonds, whose income is exempt from federal tax.
For more information on figuring out what tax bracket you're in, be sure to check out the IRS website. In general, though, although your tax bracket can be a useful piece of information to know, remember that its impact may not be as large as you once feared.
Taxes are an important factor in investing, the best investing approach is to choose great companies and stick with them for the long term. In our free report "3 Stocks That Will Help You Retire Rich," we name stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.