How tax rates and brackets work can be a source of confusion for many people.
Let’s use this jar and some candy to help us see how they function. The lines mark the tax rates. The spaces between the lines are the tax brackets – they show the range of income taxed at each rate. As your income moves up, only the portion that falls within the next bracket is taxed at the higher rate, and your final tax bill is a blend of the different rates. Let’s look at an example with a married couple filing jointly.
Together they make this much, but that number is reduced by their deductions. They can take either the standard deduction or they can itemize, and subtract whichever is greater. We’ll use the standard deduction, which reduces their total taxable income. As we pour those taxable dollars into the jar, they cover the first, second and third brackets. While 22% is the highest rate they pay it doesn’t apply to all of their income. When we add up the taxes due from each bracket, this is their total. And when we divide the tax they owe by their total income, we get their effective tax rate of 14.9%. And that’s the rate that really matters.
Consult a tax or financial planning professional to see how specific tax rates and brackets may impact your personal situation. For more tips on managing your taxes efficiently, watch the other videos in this series, and visit schwab.com/taxstrategies.
