Common Tax Bracket Mistakes February 9, 2006
I’ve talked about saving to get to the next income bracket, but I’ve been asked about how we can lower our tax bracket in order to pay less to our government. It’s true that for most of us, we try to make more money by getting a raise, working longer hours, or supplementing our income with another job. But there are strategies to increase your deductions to lower your taxable income. What many people incorrectly believe that in a graduated income tax structure, like the USA has, your tax will suddenly increase by a huge amount when you move into a higher tax bracket. This thinking is what the mortgage industry is taking advantage of…that borrowers will take on larger mortgage interest obligations under the “you’ll pay less tax” theory.
Congress establishes tax rates that apply to different levels of taxable income. Currently the rates vary from 10% to 35%. The higher your income, the higher your tax rate. The range of income where you stay at any particular rate is known as a tax bracket. For a single person in 2005 the rate on taxable income between $29,700 and $71,950 is 25%, so those numbers establish the 25% bracket.
Common Mistakes (from Fairmark.com)
There are several points of confusion that often come up in connection with tax brackets.
Tax brackets and earnings: Some people have in mind the general notion that their tax bracket depends on how much they earn. That’s roughly true. But it doesn’t mean you can hold onto the same tax bracket as long as your earned income stays the same. Your tax bracket depends on your taxable income, regardless of the source of that income. For example, you can move into a higher tax bracket because of increased investment income or a distribution from a pension plan — or even because of a decrease in your deductions.
Sudden change in tax: Another misconception is the notion that your tax will suddenly increase by a huge amount when you move into a higher tax bracket. For example, if your taxable income is in the 15% bracket, but just a few dollars below the 25% bracket, you might be concerned that earning a few dollars more will cause you to pay a lot more in tax. Relax. The first $100 dollars you earn in the 25% bracket will cause your tax to increase by $25. You still pay only 15% on all the money you earned below the 25% bracket.
Tax brackets and withholding: Don’t confuse tax brackets and withholding rates. The relationship between your tax bracket and the amount of tax your employer withholds is very indirect. Withholding rates are based on averages, not specific tax brackets. For example, your withholding rate may be about 20%, even though there’s no tax bracket between 15% and 25%.
Borders between tax brackets: Your taxable income may happen to fall very close to the border between two tax brackets. If it does, you can make a mistake when you use your tax bracket to estimate your tax consequences.
Example: You’re single and your 2005 taxable income is $29,600. That puts you in the 15% tax bracket. But if you have an additional $1,000 of taxable income you’ll pay almost $250 more in taxes. The reason is that even though you’re in the 15% bracket, you’re very close to the 25% bracket.
Tax brackets and marginal rates: In some cases the added tax you pay when your income goes up isn’t the same as your tax bracket. That’s because the added income can cause you to lose some other tax benefit. For example, added income can mean smaller itemized deductions or a reduction in the amount you claim for your exemptions. You may find that $1,000 of added income causes your tax to go up by $292 even though you’re in the 28% bracket. Your tax bracket is just an approximation of the added tax. To be more precise, we would say you have an effective marginal rate of 29.2%. In most cases, the tax bracket is close enough to the effective marginal rate for purposes of making investment decisions.
So yes, we can lower our taxable income, but keep in mind that real financial freedom comes from saving more, not spending less on taxes.
Source:
Fairmark.com Tax Guide for Investors
Thank you for the information!
- Posted in : USA Federal Tax Info, Wage info
- Author : Kyle
Comments»
[…] I’ve mentioned before that in some cases the added tax you pay when your income goes up isn’t the same as your tax bracket. Some don’t realize that your tax bracket is the rate you pay on the “last dollar” you earn. As a percentage of your income, your tax rate is generally less than that. […]
My husband just got an offer for a new job which will earn about $100K per year. We are newly married with a child on the way and I am trying to figure out if I should even bother to work part time…in case it will put us in a higher tax bracket, therefor we would be using my income, basically, to pay the taxes. Any advise for us? We’re also considering leasing at least one car because we can write that off as a deduction for his business…right?
Thanks for any info.
Paula
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