Most of us have only a basic understanding of how tax brackets work, so let's go over a few things about the 2014 tax brackets that aren't well understood.
For example, just because you earn $70,000 per year doesn't mean you'll be put in the tax bracket that corresponds with that income level. And if you're in the 25% tax bracket, you won't pay anything close to 25% of your income in federal income taxes.
Here's a crash course on tax brackets and what they mean to your tax liability.
Based on your taxable income only
The tax bracket you are in is determined by your taxable income, which is always lower than the amount of money that you actually make. Specifically, it is your income minus all of the deductions you're entitled to. So, if you earn $80,000 and qualify for $22,000 in various tax deductions, your taxable income is $58,000.
However, it's important to make the distinction between tax deductions and tax credits here. A tax credit is used to lower the final amount of tax you owe. It has no effect on your taxable income and therefore should not be used when figuring out your tax bracket.
What the percentage really means
This is where it starts to get a little complicated. Essentially, the tax bracket you end up in based on your income only applies to your taxable income that's above the threshold for the bracket beneath it. We'll get to an example in a minute, but first take a look at the 2014 IRS tax brackets:
This is best illustrated by an example. Consider a married couple whose taxable income is $100,000 per year. Looking at the above chart, this puts them in the 25% bracket, so you may think their federal income tax would be $25,000. Thankfully, it doesn't work like this. The correct way to calculate it is by using their bracket and all of the brackets before it. Fellow Foolish writer Selena Maranjian recently wrote a great article discussing how to determine your effective tax rate by using tax brackets.
If you're close to a 2014 tax bracket "threshold"
You can use this information to your advantage if you're close to one of the thresholds. Let's say you do some calculations at the end of the year and find that your taxable income is $77,000 (as a married couple). If you can reduce your taxable income by $3,200, you'll pay no more than 15% on any of your income.
Here are the three best ways to nudge your taxable income downward and keep everything in the lower tax brackets.
1. Max out your retirement savings
Have you contributed all that you can to your employer-provided 401(k)? Even if you've maxed out the amount your company matches, you may be able to contribute a little more. For 2014, the IRS allows elective salary deferrals (your contributions) of up to $17,500, or $23,000 if your over 50 years old.
If you max that out, or if you don't have the option of an employer-sponsored plan, you can contribute up to $5,500 to a traditional IRA that may be tax deductible, depending on your income and eligibility to participate in a plan at work. Check out the IRS' rules on IRAs to see whether you qualify.
If you're eligible, retirement contributions for the 2014 tax year can be made until the tax deadline in April 2015, so you have plenty of time.
2. Sell some losing stocks
If you bought some stocks that turned out to be duds, now may be a great time to cut your losses. The IRS lets you deduct up to $3,000 in investment losses from your taxable income, and if your losses are even greater, the difference can be carried over to next year's tax return.
So, even if the rest of your portfolio is doing wonderfully, you can get a nice tax deduction by selling your losers and letting your winners continue to make money.
3. Donate a little more
This could be a good reason to increase your charitable contributions for the year.
Another thing to consider: As you might expect, people generally scramble to get their charitable donations in by the end of the tax year. So, if it looks like you may need a few extra deductions this year, consider making your donations around midyear, when charities can really use the money.
As with anything else in personal finance, the more you know about a topic, the better equipped you'll be to make sound decisions for your own financial situation. And understanding how the 2014 tax brackets work can help you plan your own tax strategy more effectively and efficiently.
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