Did you get or are going to receive a bonus or some other type of increase to your income? Your initial reaction was that’s great but then there was a voice in your head that said “Wait, is that going to put me in a new tax bracket? Maybe this is not so great.” Lately I have noticed there seems to be a lot of confusion as to how the tax brackets work. It’s time to bust some tax bracket myths.
Brief history of tax brackets
Currently we have seven tax brackets that range from 10% to 37%. Throughout the history of our income tax system the number of brackets and rates have changed noticeably. Fifty years ago, the number of tax brackets was twenty-four and the top tax bracket was 92%. In 1988 the number of brackets that existed were two with a top tax rate of 28%.
How tax brackets work
The federal income tax system is referred to as a progressive tax system. Progressive can take a lot of different meanings depending on its use. In relationship to the tax system, it means the higher the income the higher the tax rate. But does that mean if you make more money suddenly all your income now becomes taxed at a higher rate? This is the crux of the confusion.
All taxpayers are subject to the same tax bracket schedule. If you have 10 million in taxable income some of that income would be taxed at a 10% rate. Obviously in this case you would have a much greater amount of income taxed at 37% but you still would have income taxed at the lower rates. Let’s put it in simpler terms.
If I am single and my taxable income is $85,000 my tax would be based on the first $10,275 at 10%, the next $31,500 at 12% and the remaining $43,225 at 22%. If I receive a bonus of $10,000, I then jump into the 24% bracket. The 22% bracket in 2022 for a single individual ends at taxable income of $89,075. Does that mean because of the $10,000 bonus I now must pay 24% on all my income? The answer is no-the income that exceeds the 22% bracket which in this case is $5,925 would be taxed at 24% but the calculation remains the same for the other portion of your income.
$10,275 at 10%; $31,500 at 12%; $47,300 at 22% and then $5,925 at 24%.
There are a couple of other important items to consider. The tax brackets are applied to taxable income. Taxable income reflects your gross income less your itemized or standard deduction. As your income increases you may lose the benefits of some tax credits such as the higher education credit. Your ability to deduct a loss from your rental property may be impacted. Long-term capital gains and qualified dividends are subject to tax at a different rate and if your income meets certain levels, you may be subject to an additional tax referred to as the net investment income tax.
Now that you know a little more about how the tax brackets work celebrate your bonus and know that while there is not much left after the taxes are deducted you have not now subjected all of your income to a higher rate.
If you have any questions about tax bracket myths, contact your Henry+Horne tax advisor.
Cheryl Dickerson, CPA