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Your Tax Bracket Doesn't Mean What You Think It Means

The Motley Fool logo The Motley Fool 2/2/2018 Dan Caplinger

Video by GoBankingRates

Americans will celebrate the lower tax rates that the new tax reform law brought at the beginning of 2018. By retaining the seven tax brackets that existed under previous law but lowering the rates that apply to most of those brackets, tax reform gave taxpayers a highly visible tax cut that on its surface seems easy to measure.

Yet what often confuses taxpayers is how the tax bracket they're in doesn't necessarily equate with what they're effectively paying in taxes every year. That's because as simple as the concept of a tax bracket sounds, it's easy to get tripped up by the way that they work. Below, you'll learn some of the common mistakes people make with tax brackets along with the answers you need in order to make smart decisions.

Inching into a higher tax bracket isn't a catastrophic event...

Perhaps the most common misconception about tax brackets is that they define how much you pay in tax on your entire income. That's why you'll hear complaints so often that higher income pushed someone into a new tax bracket -- as if moving higher up the income scale could somehow make taxpayers worse off than if they'd earned less. But that's not the way tax brackets work.

Sometimes, you'll hear people refer to your marginal tax rate as another term for your tax bracket. The key word there is "marginal" -- it points to the fact that the rate gets charged only on the last dollar you earned. The other lower rates still apply to most of your earnings.

An example can make this clearer. Say that you and your spouse are joint filers and have taxable income of $77,000 in 2018. Under the brand-new 2018 tax brackets reflecting tax reform, that puts you in the 12% tax bracket, and your tax would be $8,859.

Now, let's look what happens if you get a $500 year-end bonus that takes your income to $77,500. You'd now be in the 22% bracket, which started at $77,400 in taxable income. The fear that many taxpayers have is that you'll have to pay roughly 22% of the full $77,500, which would almost double your taxes to more than $17,000. Instead, though, the 22% rate applies only to the marginal $100 amount that's in that final bracket. The rest gets taxed at 10% and 12%, and so the net tax is $8,929 -- just $70 higher and still giving you an effective tax rate of roughly 11.5%.

... but knowing your tax bracket is still important

Despite this common misconception about tax brackets, there are decisions you have to make in which you'll need to know the marginal tax rate rather than the effective tax rate. That's especially true whenever you decide to boost your taxable income, whether by selling a stock that's gone up in value, taking a taxable distribution from a pension or 401(k) plan, or starting to work a side job to bring in extra cash.

In these situations, you're apt to make the opposite mistake as the one above. Let's look at the second example above one more time. If you know your tax liability, then it's tempting to conclude that your effective tax rate will apply to any additional income. By that logic, if you earned $10,000 on the side or took a $10,000 traditional IRA distribution, you'd expect to pay taxes on about 11.5% of that, or $1,150.

But the way marginal tax rates work, even if you're just barely into the 22% tax bracket, any extra income is going to get taxed at that 22% rate. The additional $10,000 leads to tax of $2,200, or almost double what you expected. Again, that doesn't impose 22% on your entire income -- just the extra $10,000.

Don't let tax brackets trip you up

These might look like trivial points, but failing to understand the ins and outs of tax brackets can lead to mistakes that could cost you thousands of dollars. By knowing how tax brackets work and the math behind them, you'll be smarter in picking up money-making opportunities while being fully aware of the tax consequences.

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