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Overview: Get tax bracket knowledge for dummies, including what happens when you move up a tax bracket and how to avoid moving up.

We’ve been talking about taxes for some time now because 1) tax season is right around the corner 2) this is one of the more difficult financial topics to cover and 3) many people want to know where their money is going especially when owing taxes.

>> READ MORE: The Ultimate Guide to Filing Taxes in 2022: Deductions, Credits, & More

This is financial knowledge made easy (or tax brackets for beginners to be more specific). This means you don’t have to be in the financial industry or even be some sort of aspiring financial guru to make sense of this article and benefit from the information.

The 2022 tax season began Monday, Jan. 24, and the IRS started accepting taxpayers’ returns. Most Americans have until April 18 to file, though they can request a six-month extension to Oct. 17.

You can read more about the 2021-2022 tax filing season here.

With tax season upon us, it’s a perfect time to address those not-so-fun matters that linger in the deepest corners of taxpayers’ minds. The main points we’ll be covering in this article are:

• What ARE tax brackets?
• How do tax brackets actually work? [Video included]
• What happens when you move up a tax bracket?
• How to avoid moving into a higher tax bracket & reduce your taxable income

WHAT ARE TAX BRACKETS?

For beginners, a tax bracket refers to a range of incomes subject to a certain income tax rate, according to Investopedia.

Tax brackets result in a progressive tax system, in which taxation progressively increases as an individual’s income grows (talk about “more money, more problems”).

With this system, low incomes fall into tax brackets with relatively low income tax rates, while higher earnings fall into brackets with higher rates. But don’t worry, we’ll address more of this low-high tax situation throughout the article.

For tax years 2021 and 2022, there are seven federal tax brackets. Each is assigned a different rate, ranging from 10% to 37%, with the dollar ranges in each varying for single filers, married joint filers (and qualifying widow[er]s), married filing separately filers, and head of household filers.

However, tax brackets are not to be confused with tax rates.

TAX BRACKETS VS. TAX RATES: Tax brackets and tax rates are both used to calculate the total taxes owed. The difference is that each tax bracket corresponds to a tax rate. Taxpayers use a tax bracket to determine what their taxes due are.

>> CONTINUE READING: What’s the Difference Between a Tax Rate and a Tax Bracket? 

HOW DO TAX BRACKETS ACTUALLY WORK?

One common misconception that beginners have when it comes to understanding federal tax incomes is that having a higher salary could somehow mean making less money.

In fact, some people worry that if their income increases enough to push them into a higher tax bracket, their overall take-home pay, or net income, will decrease. They might think that getting a raise, especially a small one that nudges them into that next bracket, will actually hurt them.

TD Ameritrade, a YouTube channel, posted a video where Education Coach Michael Kealy explains tax brackets and clarifies common misconceptions such as the one mentioned above.

Here are some of the key points to understand:
• Being in a certain tax bracket does NOT mean that all your income gets taxed at that rate
• Since U.S. federal income taxes are progressive, additional income is taxed BUT they’re done so at marginally, meaning not all of your income is taxed at the same rate
• Income is divided into different levels (brackets) that have different tax rates so each dollar of income is taxed at the bracket it falls into

Kealy uses a great “bucket” analogy to explain how your income is divided, and into what “bucket” of tax percentage it falls into. Watch the 3-minute video below for details.

>> WATCH VIDEO: How Do Tax Brackets Actually Work?

 

In addition to the video, we encourage you to browse the TD Ameritrade YouTube page. They post weekly educational videos on investing and finance that are easy to understand.

WHAT HAPPENS WHEN YOU MOVE UP A TAX BRACKET?

It seems like that saying “more money, more problems” that we mentioned earlier is coming to bite us in the butt. This section is for the times you’ve heard someone complain about making more money… or maybe you’re that person complaining.

This complaint is made under the assumption that when someone moves “up a tax bracket,” every dollar they earn is taxed at a new, higher rate leading to lower take-home pay overall.

We’ve already been helped to understand that this isn’t entirely true, thanks to Kealy’s bucket analogy in the previous section. So, what exactly does moving up a tax bracket mean?

HOW YOU TAKE HOME MORE MONEY WHEN YOU EARN:

As you earn more money, you’ll pay more in taxes. And when you cross into a new tax bracket, some of the money you earn will be taxed at a higher rate. But not all your money will be taxed at that higher rate. When you earn more money, you should see a bigger paycheck.

EXAMPLE:
Suppose your taxable income is $40,000 a year and you get a $2,000 raise, making your taxable income $42,000. Previously, your highest tax bracket was 12% because your income didn’t exceed $41,775. Now your highest tax bracket is 22%. But only $225 of your income ($42,000 – $41,775) will be taxed at that rate. The rest will be taxed at 12% or less. (Source)

The above example goes hand-in-hand with what Kealy was explaining in his video. We see more clearly how our income is split up when we make more money and “enter” a different tax bracket.

ARE THERE ANY CONS TO THIS:

The one caveat to this is that many raises coincide the start of the year. That’s also the time when your benefits change. In some cases the rising cost of health insurance (or other changes you make) could cause you to see less money in your check even though you’re earning more.

The College Investor breaks down different scenarios such as a married couple filing jointly or a single filer.

Read the full article HERE.. The chart highlights tax rates, incomes brackets, tax owed, and the different examples people could find themselves in.1

HOW TO AVOID MOVING INTO A HIGHER TAX BRACKET & REDUCE YOUR TAXABLE INCOME

It pays to file taxes in the lowest possible bracket during any tax year, so you should reduce your taxable income as much as possible. And with a few shrewd moves throughout the year, you can reduce your taxable income and maybe even drop from a high tax bracket to a lower one.

Here are 6 options that can help lower your tax bracket, according to Yahoo! Finance (you can read more of their options here):

1) Taxes and… Marriage?
Don’t get married just to save a few bucks during tax season. But married couples might save money by filing jointly — especially if one spouse doesn’t work or earns much less than the other.

2) Retirement and Savings
Contributing to your employer-based retirement plan helps you save for retirement and also immediately lowers your taxable income — as every dollar you contribute is a dollar less you’ll have to pay taxes on when you file.

3) Donations, donations, donations!
Who doesn’t love a cheerful giver? Generally speaking, donations to charity are tax-deductible, meaning you can write off IRS-qualified charitable contributions and donations to decrease your taxable income, which could lower your tax bracket.

4) Get Educated
College and university students — or the person who pays for their school expenses — are entitled to several tax deductions. If you’re in school, you can reduce the amount of your taxable income by up to $4,000 if you’re paying at least that amount in tuition costs. You can also write off certain related expenses such as student fees.

5) Don’t Sell Too Many Assets
Say you have a stock that’s gone up in a short period of time. You’d like to sell it and cash in on those gains. Consider selling some of the shares in one year, and some the next, if selling the stock would put you in a higher tax bracket. If you’ve held a capital asset, such as stock, more than one year, you may qualify for long-term capital gains rates, which are even lower.

6) Farmers and Fisherman Unite!
Prior to 1987, all taxpayers could use income averaging. Now, you must be in a farming business or working as a fisherman to benefit from it. You can use income averaging to smooth their income out over a three-year period. Doing this can help keep income spikes from pushing you into higher tax brackets.

>> READ MORE: 5 Ways to Avoid Bumping Your Income into a Higher Tax Bracket

IN SUMMARY

As much as we all want to save money, we should never attempt to conceal income or cheat on your taxes — ever. The risks dramatically outweigh the potential rewards, and the likelihood of getting caught is high.

Instead, use every legal tool at your disposal to minimize your taxable income and take every deduction that you qualify for.

Don’t know where to start? Get with a professional financial expert such as an accountant or bookkeeper to help answer your inquiries about income tax, bookkeeping, or payroll services.