The U.S. tax code can be a challenge when calculating your tax liability. It is time-consuming and tedious. For example, if you fall into the 22% tax bracket, that doesn’t mean that your entire income will be taxed at 22%. This is because the tax system is progressive.
A progressive tax system means that different levels of your income are taxed at different rates. This article will explain how the progressive tax system works and how to calculate your tax liability.
Start With AGI
Your tax liability isn’t calculated on your gross earnings. It is calculated on your AGI or adjusted gross income. AGI is your total income from all sources minus deductions and credits. Income sources include wages, investments, and retirement income.
Once total income has been calculated, deductions and credits are taken out, reducing taxable income. For example, many people take the standard deduction. Married couples filing jointly receive a $25,100 standard deduction for the year 2021. If the couple made $150,000 from all sources of income, their taxable income reduces $124,900 after the standard deduction is applied. The $124,900 figure is the couple’s AGI.
The standard deduction is inflation-adjusted. This means it periodically increases. For those who are married filing jointly, they’ll get a $300 increase in 2021 over last year’s standard deduction.
Find Your Tax Bracket
Once AGI has been calculated, it’s time to find your tax bracket and apply the amount of taxes owed.
Below are the income tax rate/brackets for 2021.
|
Rate |
Single |
Married Filing Jointly |
Heads of Household |
|
10% |
Up to $9,950 |
Up to $19,900 |
Up to $14,200 |
|
12% |
$9,951 to $40,525 |
$19,901 to $81,050 |
$14,201 to $54,200 |
|
22% |
$40,526 to $86,375 |
$81,051 to $172,750 |
$54,201 to $86,350 |
|
24% |
$86,376 to $164,925 |
$172,751 to $329,850 |
$86,351 to $164,900 |
|
32% |
$164,926 to $209,425 |
$329,851 to $418,850 |
$164,901 to $209,400 |
|
35% |
$209,426 to $523,600 |
$418,851 to $628,300 |
$209,401 to $523,600 |
|
37% |
$523,601 or more |
$628,301 or more |
$523,601 or more |
From the previous example, the couple made $150,000, but their AGI is $124,100. This puts them in the 22% tax bracket. That doesn’t mean they will owe $124,100 x 0.22 = $27,302.
The U.S. tax system is progressive. We can see there are seven rates for each filing status. These rates range from 10% to 37%. This married couple’s income will be taxed in three stages — 10%, 12%, and 22%. Here’s how it is calculated:
0.10 x $19,900 = $1,990
0.12 x ($81,050 - $19,901) = $7,338
0.22 x ($124,100 - $81,051) = $9,471
Total tax liability: $18,799
Effective Tax Rate
From the previous section, we saw how the tax system is progressive. What if you want to know your tax rate? Using the above example, do you average the three tax brackets?
No. The above example has an AGI of $124,900, with the highest tax bracket being 22%. We say that this person’s marginal tax rate is 22% (the highest bracket applied to the tax filer).
To find a more accurate tax rate, we want the effective tax rate. This is found by dividing the tax liability by the AGI. The example tax filer has an effective tax rate of 7.63%.
9,471 / 124,900 = 7.58%
Additional Taxes
Some tax filers will be subject to the NIIT (net investment income tax) and AMT (alternative minimum tax).
The NIIT is a 3.8% investment income tax that is based on filing status and income level. Rather than AGI, it uses your MAGI (modified adjusted gross income).
The AMT is used to ensure everyone is paying their fair share of taxes. Some people may apply so many deductions and credits that they greatly reduce their tax bill or don’t even owe taxes. This is where tax filters can trigger the AMT.
Less than 5% of taxpayers end up owing anything on the AMT. But 60% of taxpayers making between $200,000 and $500,000 annually trigger the AMT.
Estimated Quarterly Tax Payments
Estimated quarterly tax payments can help to avoid a large, unexpected tax bill in the following year. Quarterly payments chip away at your estimated annual tax bill. When done right, many taxpayers have a lower tax bill or may even receive a refund for paying too much. This makes their income tax bill manageable.
Another advantage of estimated quarterly tax payments is that you avoid underpayment and penalties.
At the beginning of the year, if you estimate that your tax liability will be at least $1,000, you must make quarterly estimated tax payments. Self-employed individuals must also make quarterly payments.
The schedule for quarterly payments is:
- Q1 (Jan-Mar) due April 15
- Q2 (Apr-May) due Jun 15
- Q3 (Jun-Aug) due Sep 15
- Q4 (Sep-Dec) due Jan 15
Notice that some quarters aren’t exactly three months. Q2 is only two months, while Q4 is four months.
The U.S. tax code is complex, which makes calculating your tax liability a complex process. That’s why it is best to work with a tax adviser to determine the amount of taxes you will owe.
