Understanding how tax brackets work

Difference between marginal and actual tax rates explained

Recently I had a client in and they were a bit surprised by the balance that they owed the IRS. They had just begun receiving Social Security and were still working. In addition, they worked a fair amount of overtime this past year.

As a result, their taxable income had increased over the previous year. They were surprised, confused and disappointed to learn that they owed money because of this additional income.

The big misunderstanding appears to be the fact that many taxpayers are not clear on the difference between marginal tax rates and actual or average tax rates.

The rates listed within each bracket are not the actual rates, but are the marginal rates.

A marginal rate means that the rate is applied to each bracket before moving onto the next bracket. Another way of looking at it is that the marginal rate is that rate paid on the next dollar of income.

The misperception appears to be that some individuals believe that if they make a little bit more money this will move them into a new bracket and ultimately this will cost them significantly more overall in taxes. Our tax structure is simply not set up this way.

The individual may pay a higher rate on this additional income, but the previously earned income will not be taxed at a higher rate than it would already be taxed at simply because the individual has additional income.

However, the result of these tax brackets is that there is a disincentive to make more money, as the more money you make the greater the tax rate on that additional income.

Contrary to popular belief you do not pay the same tax rate on all your income.

Rather, your tax bracket tells you the rate of tax you will owe on income that falls within that bracket.

Taxes are assessed marginally where the tax rate is applied to each tax bracket before the next tax bracket and then the next tax bracket’s rates are assessed. This means that the actual or average rate of taxation will always be less than the percentage in the bracket for which one’s total income falls.

In 2022 we presently have six different brackets ranging from a low rate of 10% to the top marginal bracket of 37%.

The above table shows the various brackets by filing status.

To understand how this would work, if a Married Filing Jointly couple has $180,000 of taxable income then they will pay 10% tax on the first $20,550 of income; $12% tax on the next $63,000 of taxable income that fell between $20,551 and $83,550; 22% tax on the next $94,600 of taxable income from $83,551 to $178,150; and 24% tax on the last $1,850 of taxable income that was over $178,151 and less than $340,100. So, the total tax paid on the $180,000 of taxable income is $30,871 which is an actual or average rate of 17.15%.

This compares to the marginal rate of 24% that the taxpayer would be paying in this example.

So what we have learned from this is that the more you make, the larger the government’s share of your income.

Knowing your tax bracket and where you fall in that tax bracket can help you with tax planning.

For instance if you expect to be in a lower tax bracket in future years, then you might want to consider deferring income into future years as well.

Understanding how these tax brackets work hopefully will clarify some misperceptions and help everyone be better prepared come tax filing time.

Paul Pahoresky is the owner of PRP & Associates. He can be reached at 440-974-1040 extension 214 or at paul@ prpassoc.com. Consult your tax advisor for your specific situation for additional information and guidance on these topics.