Tax brackets are one of the most commonly misunderstood aspects of taxes in America. News reports about taxes often do little to clear up those misunderstandings, sometimes making it seem that people are going to owe a much larger portion of their income to taxes than they actually do.
Tax brackets aren't that difficult to understand, particularly if you can visualize a multi-tiered water fountain in your head. Let's dive in.
2021 income tax brackets
Taxpayers filing single
Married taxpayers filing jointly
Up to $9,950
Up to $19,900
A single file taxpayer will only pay 10% of their income up to $9,950.
A couple filing jointly will pay 12% tax on the income they earned between $19,901 and $81,050, but 10% on the first $19,900.
A single file taxpayer will pay 22% of tax per $1 earned, starting at $40,526.
A couple filing jointly will pay 24% tax on the dollars earned between $172,751 and $329,850.
A person filing single will pay 32% taxes on the income they earn over $164,925, and up to $209,425.
Tax payers in this bracket will pay 35% on all income earned over $209,425 or $418,850 depending on their filing status
Source: Internal Revenue Service
Expressed like this, tax brackets are easy to misunderstand. The most common misunderstanding is that these represent how much you'll pay on all of your income. If your total income puts you in a particular tax bracket, that is not the percentage you pay on all of your income. It is how much you pay on just that portion of your income. On other portions, you'll pay a much lower tax rate.
How 2021 tax brackets work
The best way to visualize tax brackets is to think of a tiered water fountain. There's a small cup at the top where the water begins. It fills up that small top cup, then the water overflows, down to a bigger cup. That one fills up and overflows down to the next cup, and so on down to a big pool at the bottom.
That's almost exactly how tax brackets work.
Imagine you're a single person, and your income is like the water in this fountain. You pour all of your taxable income into the top cup of this fountain, the 10% cup. Once you've poured in $9,950, that 10% cup is now overflowing, and the excess flows down into the 12% cup. Once you've poured in $40,525 in total, that 12% cup is now overflowing as well, and the excess pours down into the 22% cup. Once you've poured in $86,375 in total, that 22% cup is now also overflowing, so the excess pours down into the 24% cup. It keeps going like this until you've poured in $209,425 in total, at which point any additional income that you pour in goes into the 35% cup.
So, you end up with your income spread across a bunch of different cups. You have some in the 10% cup, some in the 12% cup, and so on.
For the portion of your money that's in each cup, you only pay the percentage tax rate for that specific cup. If you have $9,950 in that 10% cup, you only pay a 10% tax on that portion of your income. If you have $20,000 in the 12% cup, you only pay a 12% income tax on that $20,000 portion of your income, and so on.
A real-world example of how tax brackets work
You're a single person who will earn $120,000 in income in 2021, but let's say you have $20,000 in deductions, so your taxable income is $100,000.
You start "pouring" in your income at the top.
- First, the 10% cup can hold $9,950 of your taxable income.
- Next, the 12% cup can hold the rest of your income up to $40,525. That's $30,575 of your income — $40,525 minus the $9,950 in the 10% cup.
- Then, the 22% cup can hold the rest of your income up to $86,375. That's $45,850 of your income — $86,375 minus the $9,950 in the 10% cup and $30,575 in the 12% cup.
- Finally, the 24% cup can hold the rest of your income up to $164,925. That's $13,625 of your income — $100,000 minus the $9,950 in the 10% cup, $30,575 in the 12% cup, and $45,850 in the 22% cup.
So, here's what you actually have to pay:
- You have to pay 10% of $9,950, or $995.
- You also have to pay 12% of $30,575, or $3,669.
- You also have to pay 22% of $45,850, or $10,087.
- You also have to pay 24% of $13,625, or $3,270.
Add that up and you owe $18,021. You're paying a roughly 15% overall tax rate on your gross income, even though you're in the 24% tax bracket. That's because you're paying a lot less than 24% on most of your income.
For this individual, 15% is their effective tax rate, and 24% is their marginal tax rate. The effective tax rate is how much a person is actually paying on their full taxable income, whereas the marginal tax rate is what tax bracket they're in and how much they'd have to pay on any additional income.
This pattern holds true for almost any income. People actually pay a much smaller percentage of their income than the tax bracket they find themselves in.
What to consider with 2021 tax brackets
Deductions reduce how much you owe
If you have some tax deductions, that means that you're pouring less money in the fountain to begin with, so you're actually just pouring less money into the bottom bowl you can reach.
So, in the example above, if our $100,000 single income earner finds another $5,000 in deductions, that means that they're going to just have $5,000 less in the 24% bowl. They'll pay 24% on just $8,625 of their income, or $2,070. Their tax bill goes down by $1,200 because of that additional $5,000 deduction. So, tax deductions really impact your tax bill and can even sometimes bump you down to a lower tax bracket.
You'll always have some deductions
The IRS always gives you the standard deduction if you don't have many actual deductions you can verify. In 2021, this means that a single person always gets at least $12,550 as a deduction, and a married couple filing jointly always gets at least $25,100 as a deduction.
So, even if you can't show evidence of anything you can deduct, a single person can still cut their taxable income by $12,550. If you're single and make $20,000 a year, you get a $12,550 standard deduction, meaning you're only taxed on $7,450 of your income, all of which falls into that 10% bowl. Your total income tax bill is $745 — 10% of $7,450. This person is almost certainly getting a refund if they have an employer that's been taking money out of their check for taxes.
Tax credits come off your tax bill at the end
If our $100,000 single person had a $1,000 tax credit, they calculate their taxes as described above, but then their bill goes down from $18,021 to $17,021. In other words, tax credits are far better than tax deductions. They're both good, but credits are great.
The easiest way to find all the deductions and credits you're eligible for is to use tax software or hire a trusted tax preparer.
[This article was originally published on The Simple Dollar in November, 2020. It was updated in December, 2021.]