Understanding Income Tax Rates Leads to Better Financial Decisions

Once you finish this post, you'll have a better understanding of income tax rates, how you are taxed, and you will be able to make better financial decisions to save taxes.

Income tax rates are very similar to how you are charged for your electricity or water. For example, your electricity company will charge you in levels or tiers or brackets so that you pay more per kilowatt hour as you use more electrical power. Specifically they might charge you $.10 per kilowatt hour for up to 1000 kWh per month. But for the next 1000 kWh you use that month, they charge you $.15 per kilowatt hour. And for the next 1000 kWh they charge you $.20 per kilowatt hour and so on. The reason that utilities charge this way is to give you an incentive to use less by charging you more when you overuse the commodity. IRS charges you in the same way.

On your first tier of income you pay one percentage, say 15%. But then as you earn more, you are charged 20% for the next tier of income and so on as you earn more and more. Yes, believe it or not, our government gives you a disincentive to earn more by charging you more heavily as you work harder and smarter and earn more. Here are the income tax rate tables for 2012.

2012 Income Tax Rates

Single People
If taxable income is:		The tax is:
			of the
	But not		amount
Over —	over—		over—
$0	$8,700	-----------10%	$0
8,700	35,350	$870.00 + 15%	8,700
35,350	85,650	4,867.50 + 25%	35,350
85,650	178,650	17,442.50 + 28%	85,650
178,650	388,350	43,482.50 + 33%	178,650
388,350	------------	112,683.50 + 35%	388,350


Married Filing Jointly
If the taxable income is:		The tax is:
			of the
	But not		amount
Over	over—		over—
$0	$17,400	-----------10%	$0
17,400	70,700	$1,740.00 + 15%	17,400
70,700	142,700	9,735.00 + 25%	70,700
142,700	217,450	27,735.00 + 28%	142,700
217,450	388,350	48,665.00 + 33%	217,450
388,350	-----------	105,062.00 + 35%	388,350

You'll notice that IRS charges single people higher income tax rates than married people. A single person with an income of $35,350 pays $4,867 of incone tax while a married couple with the same income pays $4,432. I guess this gives you incentive to get married.

The income tax rates in the tables are the percentage of taxable income that you pay to the government. Taxable income is not your total income. It is basically your total income minus your deductions. So if you earn $70,000 in 2012 but have $10,000 of mortgage interest and another $10,000 of deductible expenses, your taxable income would be $50,000. The income tax rate from the table would apply to $50,000. Even if you have no deductions, IRS provides everyone a standard deduction plus a personal exemption to give you a small break on your taxes.

Here's how you can apply this new knowledge about income tax rates. Let's assume that you've been paying 15% income tax on your income. You look for a new job that will pay you more. At first you think you will keep 85% of the increase in your income. But that is not the case. If the additional
income pushes you into a higher income tax rate bracket, say 20%, you will only keep 80% of the additional income you earn.

Of course, in addition to the federal income tax rates we have discussed in this post, in most states, you will also pay state income taxes.