In late 2022, the IRS announced that it would be adjusting tax brackets for the 2023 tax year as well as the standard deduction to account for inflation. That means that people who were previously in higher tax brackets may have moved to a lower bracket and would have a lower effective tax rate.
But what is an effective tax rate? And how do tax brackets even work? If you’re confused, don’t worry — you’re not alone. Let’s attempt to break it down so you understand exactly how much you’re paying in taxes and how new tax brackets may affect what you pay.
What Is a Progressive Tax System?
First, it’s important to understand that the U.S. uses a progressive tax system, which means that your income is taxed at different rates. The higher the income, the more taxes you pay on it. So, the first $11,000 of your income for tax year 2023 is taxed at just 10%. The next chunk of income, up to $44,725 for the 2023 tax year, is taxed at 12%. These numbers are, of course, slightly higher for those who file as head of household and nearly double in most cases for married couples filing jointly. The higher your income goes, the higher the taxes for that portion of your income, all the way up to 37% for those who make more than $578,125, or $693,750 for married couples filing jointly.
For reference, here’s how the IRS website has broken down the new tax brackets for 2023:
- 10% for incomes of $11,000 or less ($22,000 for married couples filing jointly)
- 12% for incomes over $11,000 ($22,000 for married couples filing jointly)
- 22% for incomes over $44,725 ($89,450 for married couples filing jointly)
- 24% for incomes over $95,375 ($190,750 for married couples filing jointly)
- 32% for incomes over $182,100 ($364,200 for married couples filing jointly)
- 35% for incomes over $231,250 ($462,500 for married couples filing jointly)
- 37% for incomes over $578,125 ($693,750 for married couples filing jointly)
As most accountants would tell you, being in the highest tax bracket is a good problem to have, especially since your income is taxed progressively and you aren’t paying 37% on your entire income, but only the amount that is greater than roughly half a million dollars.
The highest percentage of taxes that you pay is considered your “marginal” tax rate.
What Is Your Effective Tax Rate?
When tax accountants talk about your tax rate, they are usually referring to your “effective” tax rate. Your effective tax rate is lower than the highest tax bracket you fall into. Rather, it is the average of all the brackets at which your income is taxed.
To keep it simple, let’s assume you make roughly $20,000 as an individual. So, a little over half your income is taxed at 10% and the other half is taxed at 12%, so your effective tax rate is 11%.
Another way to calculate your effective tax rate is to divide the amount of tax you pay by your adjusted gross income (the amount you earned after all your deductions and tax credits are factored in). Even if two individuals fall into the same tax bracket, their effective tax rate differs based on the percentage of their income that falls into their highest (marginal) bracket.
Reducing Your Tax Liability
Of course, you can reduce your amount of taxable income to lower both your marginal and effective tax bracket with tax deductions. When you declare deductions, such as child care, college costs or career development expenses, you are reducing the amount of income that falls into your marginal bracket.
Tax credits, on the other hand, are shaved directly off your tax bill to reduce the amount you owe, but they do not change your tax bracket.
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