The jumble of numbers, regulations and ever changing rules that is the tax code is admittedly mind numbing.
Nevertheless, tax liability is one reality we can count on for the rest of our lives.
Rather than ignoring it, perhaps it’s best to try to understand tax code basics and use that knowledge to our advantage.
1. Understand why income tax brackets are important
Understanding your income tax rate is an important part of planning your personal finances.
You can use your income tax rate to figure your tax liability for unexpected income (i.e. retirement planning and/or investment income) and to calculate how much you can save by increasing your deductions.
While there are many nuances, exceptions and variations depending on your specific circumstances and needs, understanding the basics of tax brackets and employing tax-savvy strategies throughout the year can add up to significant savings over time.
2. Figure out what constitutes taxable income
Taxable income is the amount of income left over after you’ve made pre-tax contributions to your 401(k) and subtracted any tax breaks to which you are entitled.
You will be using your total taxable income to determine which income tax bracket you fall into.
Going beyond just your regular salary, taxable income could include tips (think servers and bartenders), capital gaines, lump-sum distributions, stock options, canceled debt and more.
For a complete list, check IRS Publication 525: Taxable and Nontaxable Income.
3. Determine your marginal tax rate
When people refer to their income tax bracket, they’re generally speaking of their marginal tax rate, or the percent at which the highest portion of their income is taxed.
For instance, if you report $85,000 of taxable income for 2014, your marginal tax rate is 25 percent — the rate at which the last dollar of your $85,000 is taxed.
However, portions of income fall into different brackets. In this case, $1 to $9,075 is taxed at 10 percent, $9,076 to $36,900 is taxed at 15 percent and $36,901 to $85,000 is taxed at 25 percent.
The following chart shows the new 2014 Income Tax Bracket breakdown:
|Table 1. 2014 Taxable Income Brackets and Rates|
|Rate||Single Filers||Married Joint Filers||Head of Household Filers|
|10%||$0 to $9,075||$0 to $18,150||$0 to $12,950|
|15%||$9,076 to $36,900||$18,151 to $73,800||$12,951 to $49,400|
|25%||$36,901 to $89,350||$73,801 to $148,850||$49,401 to $127,550|
|28%||$89,351 to $186,350||$148,851 to $226,850||$127,551 to $206,600|
|33%||$186,351 to $405,100||$226,851 to $405,100||$206,601 to $405,100|
|35%||$405,101 to $406,750||$405,101 to $457,600||$405,101 to $432,200|
Source: Internal Revenue Service
Your marginal tax rate is important, as it is the rate you use to calculate the value of a deduction. In this case, with a marginal tax rate of 25 percent, a $100 deduction would reduce your tax by $25.
4. Calculate your effective tax rate
While your marginal tax rate is the rate at which the last dollar of your taxable income is taxed, your effective tax rate is the overall percentage of your taxable income paid in income taxes.
That rate will be lower than your marginal rate because much of your income is taxed at rates lower than your top rate, as shown in the example above.
To find the exact value of your effective tax rate, simply divide your total tax expenses by your taxable income.
5. Account for your combined tax bracket
The tax brackets in the chart above refer to Federal income taxes. Your combined tax bracket is the sum of your federal tax bracket and your state tax bracket minus the amount of state taxes you can deduct from your Federal return.
The combined tax rate is important, as it determines how much tax you’ll owe on income from investments.
Click here for a complete list of state personal income tax rates for 2014.
6. Find ways to lower your tax bill
Don’t stop once you’ve calculated your expected tax expenses! Here are a number of ways to reduce your tax burden:
• Contribute to a 401(k) or deductible IRA.
The more you contribute, the more you reduce your taxable income for the year. However, be sure to account for contribution caps.
• Utilize tax-free savings and investment vehicles.
Tax-free mutual funds, money market funds and bonds are readily available online and are generally municipal and treasury bonds backed by government entities.
• Take advantage of capital losses.
You can use capital losses to offset capital gains on taxable accounts of stocks and funds. Any excess capital loss can be used to offset other income up to $3,000.
• Keep your W-4 up to date.
If you’ve recently married, had a child or qualified for any other allowances, be sure to update your tax filing status with a new W-4 form from your employer.
New allowances will reduce the amount of taxes withheld from your paycheck, increasing your take home pay.
To claim any of these tax breaks, you must choose to itemize your deductions. However, if the standard deduction exceeds the aggregate of your itemized deductions, even with all the strategies applied above, the standard deduction will provide you with the most tax savings.
Although tax season doesn’t begin until Jan. 1, it’s never too early to start thinking about your taxes.
Photo credit: Flickr/StockMonkeys.com, nocookie.net, imgflip.com, quickmeme.com