What is gross income? How it works and why it’s important
A person’s gross income is used to determine how much they have to pay toward federal and state income taxes.
3 MIN READ
Jun. 2, 2021
What is a tax bracket?
The tax rate applied to high-income earners is greater than that applied to those who earn less. The method used to manage the increase in taxes is through the use of tax brackets. For example, a single person earning more than $418,400 per year is placed in the highest tax bracket and pays 39.6 percent tax on all income above $418,400, while someone earning slightly less will be in the 35 percent tax bracket.
Deeper definition
In a progressive tax scheme, a taxpayer’s tax liability increases the more the person earns. The increase in the tax rate is not linear, and the IRS sets certain income bands to which a fixed marginal rate of tax applies. These are known as tax brackets. There are four major tax categories:
- Single files.
- Married and filing jointly.
- Married and filing separately.
- Head of household.
Each taxpayer falls into one of these categories, depending on their circumstances.
Within each schedule, there are a number of tax brackets. When someone falls in a particular tax bracket, say at 25 percent, it’s tempting to think that all income is taxed at 25 percent. This is not the case:
- All income up to $9,325 is taxed at 10 percent.
- Income above $9,325 and below $37,950 is taxed at 15 percent.
- Income above $37,951 and less than $91,900 is taxed at 25 percent.
Consequently, the average tax rate is lower than the marginal rate of the tax bracket that the taxpayer falls into.
Tax bracket example
Nicholas has recently graduated from college. He is confused about tax brackets because colleagues complain about the cost of moving into higher tax brackets. His understanding is that he’ll have less take-home pay.
He consults with a tax adviser who explains the higher tax rate only applies to that portion of income that’s above the cutoff point for the bracket. As he is earning $90,000 now, his taxes before adjustments is $18,240 (20.3 percent). After an increase to $93,000, his tax increases to $19,022, while his average tax rate increases slightly to 20.5 percent. His take home pay has increased by $2,218.
