Paying the correct income tax is crucial for every business owner in order to remain compliant with legal and financial responsibilities. The United States levies income tax along with specific income slabs, and the higher your income is the greater shall be your income tax. A lot of business owners tend to not understand how the tax rates work and what their specific income tax rate is. Hence, in this small article, you will learn about the several ways by which you can work with income tax brackets
How does the tax bracket work?
The United States uses a progressive tax system which means that people who have a higher taxable income need to pay up more in their federal income taxes.
But it is essential, that you also understand the following:
1. When you are in a specific tax bracket, it does not mean that you will have to pay the exact federal income tax rate on all the income that you are making. The tax bracket system only provides a certain framework where you have to pay taxes based on your income. People with a lower income amount will need to pay lower taxes.
2. The government shall decide the amount of tax that you need to pay. This is done by dividing your taxable income into several chunks. These chunks are termed as tax brackets. Each chunk is taxed at the corresponding income tax rate. This creates a system where, no matter which specific bracket you are in, you would not have to pay your taxes based on your whole income.
3. Thus for instance, if you are filing your income as a single person who has a net $ 32000 income which is taxable, then you will fall in the 12 % tax bracket for 2020. However, you do not have to pay 12% on all the $32000. Instead you need to pay 10% for the first $9000 and 12% on the rest.
4. In case, your net income is $50,00 then you will have to pay 10% for the first $ 10000, 12 % for the chunk which lies between the $10000 and $40000. And finally, you will pay 22% for anything that is beyond $40,000. Thus, the total bill would be around $7000 which is roughly about 14 % of your taxable income, even if you fall in the 22 % tax bracket. Thus, 14 % is your effective tax rate.
It is important to note that this works only for the federal income tax. The individual states can have separate tax brackets like a flat single income tax or none at all.
Calculating the marginal tax rate
The marginal tax rate is basically the tax rate that you will have to pay on a single dollar that goes above your taxable income. This basically equates with your tax bracket. For instance, as a single filer with a $30000 taxable income, you will be in the 12% tax bracket but if your income rises by $1 then you will have to pay a 12% tax on that additional dollar also. Hence, if you have $41000 as taxable income, then a lot of it would fall in the 12 % bracket while a few hundred dollars are in the 22% bracket. Hence, your marginal tax rate in this instance will be 22%.
How can you pay lower income tax by being in a lower tax bracket?
There are two ways by which you can reduce your tax bills:
1. Tax credit: This will directly reduce your taxable amount and affect the tax bracket that you are in.
2. Tax deductions will help you to reduce your taxable income by specific deductions. You should take any tax deduction that you are able to claim as these will greatly reduce the taxable income that you have and put you in a lower tax bracket. This will help you to lower tax rates.
Since, income tax is difficult to calculate hence, a lot of business owners turn to hiring professional income tax return calculator for calculating their income tax.
Income tax brackets specify the maximum tax that you can be charged but they work in a progressive system and the effective income tax rate is often quite lower than the overall tax bracket.