What is my tax bracket? And why should I care?

August 9, 2016

 

This common question is of significant importance.  It is used to make decisions that can have a lasting impact on your financial life.

 

Federal tax rates on income range from 10 to 39.6%.  The table below shows the taxable income ranges that are taxed at the different rates. Taxable income is the net amount you pay tax on after you deduct your itemized deductions and personal exemptions.

 

 

 

The most important tax bracket is your Marginal tax bracket or rate.  That is the rate at which your next amount of income will be taxed.  A very common misconception among taxpayers is that when your income jumps into another tax bracket that all of your income is taxed at that rate.  NOT TRUE!  It's just the additional income that gets taxed at the higher rate.

 

By the way, qualified dividends and long-term capital gains can qualify for a lower rate, ranging from zero to 23.8%, depending on your other income.

 

Knowing your marginal tax rate is useful for some of the following decisions:

 

  • Should I contribute to a Roth or a Traditional IRA?  Traditional IRA contributions are tax deductible and Roth contributions are not.  So, if your tax bracket is high, it might pay to make a traditional IRA contribution, or vice versa.

  • Should I buy taxable or tax-free bonds in my personal account?  Those in the highest tax brackets will have more left over after taxes if they buy tax-free municipal bonds that yield less, generally, than taxable bonds.

  • Should I shift some income, if I can, to next year?  Taxpayers with variable income can often minimize their taxes by smoothing out (or bunching) income between two tax years.  You have to know your marginal rate to make those decisions.

 

Taxpayers who live in states that have income taxes have to add their state's marginal tax rate to their Federal rate to make these decisions.

 

Asking a professional, such as your CPA is always a good idea when making decisions based on your marginal tax rate.  Ask him or her every year or so what your rate is.

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