Many US taxpayers have a difficult time understanding what marginal tax brackets are and the differences between credits and deductions. I will illustrate these three concepts for a hypothetical single taxpayer, Alex.
Alex’s Gross Income
Alex’s gross income is $225,000, all from his job, shown in solid red.
Deductions reduce your amount of taxable income.
Alex has deductions that can be found in lines 23 to 35 of his 1040 in the amount of $15,000 (patterned red). Examples of this kind of deduction include tuition and qualified fees, heath savings account contributions, IRA contributions, and moving expenses. Therefore Alex’s taxable income is reduced to $210,000 (solid red). This is Alex’s adjusted gross income (AGI).
Alex’s taxable income is further reduced by his exemption and itemized deductions, which are $10,000, found in lines 40 and 42 on his 1040.
Marginal Tax Brackets
Alex’s total taxable income (line 43 on his 1040) of $200,000 falls across the 10%, 15%, 25%, 28%, and 33% tax brackets. That means that a portion of Alex’s income will be taxed at each of these rates. The lower and upper bounds of each tax bracket and the corresponding tax rate is in the table below. You can see that both the income ranges for each tax bracket and the tax rates increase as the amount of income increases.
Here are the tax brackets applied to Alex’s income.
Alex will owe an amount of tax from each of these brackets. Here we have pulled out the amount of tax he owes from each bracket and lined them up next to his income. Remember, he does not owe any tax from the piece of his gross income that he was able to deduct. You can see that Alex owes more tax from the higher brackets both because they cover larger amounts of income and because the tax rate is higher.
This is Alex’s tax owed from line 44 on his 1040, $50,528. He would find this amount by looking it up in the IRS tax tables, but the tables are based on the calculation explained above. The mistake that most people make is thinking that their entire taxable income is taxed at their top marginal rate, but you can see that portions of their income are taxed at every rate below their top rate according to the brackets.
Credits directly reduce the amount of tax you owe.
Alex has $10,000 in credits from lines 47 to 53 from his 1040 (patterned green). These credits are directly applied to his tax owed, which goes from $50,528 to $40,528 (solid green).
You can see that the value of a deduction depends on which tax bracket your income tops out in, whereas a credit is always valued the same amount. In Alex’s case, his deductions and exemptions of $25,000 reduced his tax owed by 33% of $25,000 (aka $8,250). His credit of $10,000, on the other hand, reduces his tax owed by $10,000. If your income tops out in a lower tax bracket, deductions will be “worth” even less in terms of reducing the tax you owe.
Alex’s Tax Owed
Our hypothetical taxpayer Alex owes $40,528 in federal income tax on his income of $225,000, which means he pays a total federal income tax rate of 18%.
Disclaimer: Since this is a hypothetical example conjured to illustrate the concepts of marginal tax brackets, deductions, and credits, it is likely that some of the numbers are unrealistic or there may be nuances of the tax code that I have ignored (e.g. the AMT, capital gains income). Since this isn’t tax advice, only an illustration of the stated concepts, I hope you don’t mind!
Is there anything you struggle with regarding the basic math in the tax code? What is your top tax bracket and what kinds of credits and deductions are you taking this year? Do visualizations help you understand these confusing concepts?