With tax season approaching, you should begin thinking about filing your taxes. The 2021 federal income tax rates have changed, so you should know where you land, and how your tax bracket will affect your return.
For taxes that you must file in April 2021 or in October (with an extension), you will land in one of seven 2021 federal income tax rates. The taxes apply to the income you made in 2020. The more you made in 2020, the higher your tax bracket will be.
The tax rates include: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The two lowest 2021 federal income tax rates are for people who made under $40,125. The two highest 2021 federal income tax rates are for people who made over $207,351.
The 2021 federal income tax rates did not change from 2020, but the income amounts increased. Income tax rates changed in 2018, with the highest percentage dropping from 39.6% to 37%. The percentages have remained steady since 2018.
Understanding Tax Brackets
If you find tax brackets confusing, you are not alone. Many consider the progressive tax system in the United States rather complicated. The more money you make, the more you pay in taxes. But, your entire income determines your tax liability.
With a progressive tax bracket, you do not pay the same rate on all of your income. The federal government chunks amounts of your income into brackets and taxes it at the minimum rate. So, you never pay the largest percentage on your entire income.
Let’s say you made $100,000 in 2020. Your income places you in the fourth tax bracket, which is 24%. But, you do not pay 24% on your $100,000 income. Instead, you pay $14,605.50 and 24% of the money you made over $85,525.
If you made $100,000 of taxable income, you would pay 24% on that $14,475, which comes to $3,474. So your 2021 tax bill will be $18,079.50 or 18% overall.
You pay 10% on the first bracket of your money. Then, 12% on the second bracket, 22% on the third bracket, and 24% on what fits into the fourth bracket.
The 2021 tax brackets for single filers are:
- First Bracket: 10% of $0 to $9,875
- Second Bracket: 12% of $9,876 to $40,125 + $987.50
- Third Bracket: 22% of $40,126 to 85,525 + $4,617.50
- Fourth Bracket: 24% of $85,526 to $163,300 + $14,605.50
- Fifth Bracket: 32% of $163,301 to $207,350 + 33,271.50
- Sixth Bracket: 35% of $207,351 to $518,400 + $47,367.50
- Seventh Bracket: 37% of $518,401 and up + $156,235
Tax brackets for married couples filing jointly are:
- First Bracket: 10% of $0 to $19,750
- Second Bracket: 12% of $19,751 to $80,250 + $1,975
- Third Bracket: 22% of $80,251 to $171,050 + $9,235
- Fourth Bracket: 24% of $171,051 to $326,600 + $29,211
- Fifth Bracket: 32% of $326,601 to $414,700 + $66,543
- Sixth Bracket: 35% of $414,701 to $622,050 + $94,735
- Seventh Bracket: 37% of $622,051 and up + $167,307.50
Understanding the Marginal Tax Rate
Consider how a margin functions similarly to a border. When you are factoring in your taxes, you have to consider your marginal tax rate.
Each step into a higher tax rate involves crossing a margin. So, if you make $10,000 of taxable income, you belong in the 12% marginal tax rate. You would pay 10% on the first $9,875, the 12% remaining $125, which puts you into the 12% marginal rate.
The idea behind federal taxes is that your total taxable income fits into the marginal rate, but you pay the lower amounts on the dollars that fit into each bracket.
How to Lower Your Marginal Tax Bracket
When you look at your W2 form, you will see several numbers. One of those numbers is the amount of wage, tips, and compensation. That number is your taxable income. So, how do you lower that number?
Tax Credits
Tax credits do not lower taxable income. Instead, they lower the amount of tax you have to pay. The federal government awards tax credits based on spending and responsibilities.
For example, a popular tax credit is the Child Tax Credit that allows people to credit for raising children 16 and under. The Lifetime Learning Credit rewards people who continue their education.
With tax credits, your taxable income and marginal tax rates remain the same, but the balance you owe lowers. So, if you have $100,000 of taxable income, but you have three young children, you get $2000 per child knocked off of your tax bill.
If you have three children under 16, your $18,079.50 bill becomes $12,079.50. To qualify for the Child Tax Credit, you must have at least $2,500 of taxable income and no more than $200,000 if you are filing as a single or $400,000 if filing jointly.
The federal government has other requirements for qualifying for the Child Tax Credit. For example, the filer must have lived with the child for at least half of the year and have paid at least half of the child’s financial support. Tax advisors can provide more information.
The federal government will refund some tax credits. The federal government will send refundable tax credits to filers. Not all credits are refundable. The federal government offers tax credits to help people with lower income. The common ones include:
- Adoption Credit
- Affordable Care Act – Premium Tax Credit
- American Opportunity Credit
- Credit for Other Dependents
- Child Tax Credit
- Earned Income Tax Credit
- Foreign Tax Credits
- Low-Income Housing Credit
- Lifetime Learning Credit
- Residential Energy Efficient Property Credit
- Retirement Contribution Savings Credit
Tax Deductions
Where tax credits reduce taxes owed, tax deductions reduce income. For example, if you earn a deduction of $1000 in the 24% tax bracket, you save $240. Remember that if your taxable income lowers, so does your tax bill.
The Trump tax changes altered the way that individuals and married couples can deduct from their taxable income. A few deductions have not changed, like the home-mortgage-interest tax deduction. If you have a mortgage, all of the interest is tax-deductible.
Now, the federal government gives filers a standard deduction. They base the deduction on filing as an individual or as a couple. This deduction takes the place of the itemized deductions that once dominated tax returns.
For 2020, single filers get a standard deduction of $12,400. Couples filing jointly get a standard deduction of $24,800. People over 65 and surviving spouses get different standard deductions.
Single and married filers who have tax-deductible expenses larger than the standard deduction should file their itemized deductions. Tax-deductible expenses include student-loan interest, some health-care expenses, and small-business expenses.
Some tax-deductible expenses include
- Moving expenses
- Gambling losses
- State and local tax deductions
- Charitable contributions
- Teacher educational expenses
- Sale of home expenses
The IRS has a full list of tax deductions and tax credits.
Individuals and couples with complicated deductions should work with licensed tax preparers. Some of the more complex deductions involve home businesses because there are so many different deductions.
Some deductions have easy rules. For example, teachers can deduct up to $250 of classroom expenses. People with student loan interest can deduct up to $2,500 of it.
Filers can deduct charitable donations. Before adding a large charitable deduction, you must be able to prove that you actually donated. You must also be sure the charity that received your money is a real charity with the correct IRS filing.
With the COVID pandemic and the CARES Act, non-itemizers can deduct up to $300 if they donated cash to a qualifying organization. The charitable organizations must be either religious, educational, scientific, or literary. This is a new deduction for the 2021 tax year.
If you itemize, you can deduct cash and art, stock, cars, boats, or other valuables. Charitable organizations provide donors with receipts they can use on their tax returns. To use these charitable donations on your return, you must itemize beyond the standard deduction.
Myths About Tax Brackets
Because taxes are confusing, filers believe many myths about them.
Your Tax Bracket Is Your Tax Rate
The biggest myth about tax brackets involves how much people pay on their taxable income. They think that they pay the marginal tax rate on their entire income. No one does that. Instead, they pay the brackets on the income that falls into it.
So filers pay 10% on the first $9,875. Then, 12% on the next range of income, and so on. The truth is that your marginal tax bracket is not your actual tax rate. If you make $9,876 of taxable income, you only pay 12% on $1 and 10% on $9,875. But, you are still in the 12% tax bracket.
You Must Itemize Your Deductions
In previous tax years, this myth was true. Now that the standard deduction is so high, many filers deduct more that way than they did with itemized deductions.
Single and married filers often struggle to find itemized deductions that are more than the standard $12,400 and $24,800, respectively. With the new tax laws, you can use the standard deduction, or you can itemize. You cannot do both.
Remember, itemized deductions reduce your income by your marginal tax rate. So, if you are in the 24% tax bracket, you only save 24 cents off of every dollar you deduct.
You can use the standard deduction and tax credits. If you can find tax credits, you might be able to save more money than if you itemize your deductions.
Do Not Pay Off Loans
If you itemize your deductions, you can deduct interest off of your mortgage and your student loans.
Because of this opportunity, some people believe they should not pay off these loans. While it is nice to get some money off of your tax return, the deduction should not prevent you from paying off the loans if you can.
Keep in mind that tax deductions do not lower your tax liability. Instead, tax deductions lower your taxable income. You can deduct up to $2,500 in student loan interest. So, if you are in the 24% bracket, you save $600. So, you’ve paid $1,900 in interest.
If you are in a lower tax bracket, you save even less.
Imagine what you could do if you paid off your student loans. You wouldn’t pay any interest. In reality, having no student loan payment is a better deal than receiving a $600 deduction on your taxes.
Bonuses Aren’t Worth the Tax Increase
If you work for a company that pays bonuses, you are fortunate. If you are refusing the compensation because of tax liabilities, you should reconsider. Businesses already have rules for withholding taxes on bonuses. They usually use the 22% deduction.
Some filers think that they are paying more on their bonuses, especially if they are not in the 22% bracket. Withholding is not the same as paying taxes. Your employer may have withheld 22%, but you don’t know how much you have to pay until you file your return.
When you file your tax return, you might find that you get money back because your employer withheld more than you owe. Or you might find that you owe. You won’t know until you file. The 22% withholding should not trigger you to decline the bonus.
Let’s say you received a $1000 bonus, which turned your $100,000 taxable income to $101,000. You are still in the 22% taxable rate. So you pay $220 in taxes on the bonus, which leaves you with $780 without factoring in tax credits or deductions.
Of course, anyone having specific questions about your marginal tax bracket, deductions, and credits, should talk to a professional tax preparer.