How to Calculate Income Tax
By Trevor Onions
, last updated October 3, 2011
Good tax planning rests on your ability to calculate your personal tax rate. Although the tax code as a whole is tremendously complicated, understanding how the IRS calculates income tax is relatively straightforward. Automated software is an increasingly popular when it comes time to file, but knowing how to calculate income tax is crucial for tax planning. By doing it correctly, you may decrease your overall tax bill or expand your refund.
Using Income Tax Brackets
The best way to calculate your personal income tax is by locating your tax bracket. The Federal government uses income ranges to determine how much an individual’s income should be taxed. The current tax rates are 10%, 15%, 25%, 28%, 33%, and 35%. It’s important to note that all rates are applied to adjusted gross income.
To figure out your adjusted gross income, you need to subtract all write offs, credits, and exemptions from your earned income. Common examples of legitimate adjustments that will tug your adjusted gross income down are charitable contributions, paycheck withholding placed into tax exempt retirement accounts such as 401(K) plans, and education expenses. There are plenty of other deductions for work and business related costs as well.
The adjusted gross income is where you’ll actually see taxes applied. Although many people will say they are in a certain tax bracket like 15% or 25%, this is somewhat misleading. Due to the way income taxes are set up, understanding how tax rates are distributed across your earnings is essential.
How Tax Rates are Distributed
Income tax rates are not flat taxes intended to be applied across all earned income. Instead, the average person is actually in several tax rates, and the highest rate is only applied to the last dollars earned that fall into that bracket. For example, if you have an adjusted gross income of $50,000 in one year, you’ll find yourself in three different tax brackets.
Your first $8,500 earned will be taxed at 10%. Anything in the $8,501 to $34,500 range gets taxed at 15%. Then, all dollars over this amount are hit with the 25% tax rate. This is designed to lighten the load on low and median income earners, and goes a long way toward explaining why many people never owe the IRS additional money at tax time.
If you’re expecting a serious jump in income, then it’s wise to remember how these brackets operate. Even if you make enough to place you in the top 35% tax bracket, only your dollars over about $379,000 will be taxed. Bear in mind that brackets and rates are subject to change every year, but big changes are unlikely.
There are many benefits to calculating your personal income tax throughout the year. By tracking your tax rate, you can ensure that you’re taking the proper amount of withholding to avoid owing additional money to the IRS. If you’re on course for higher tax rates, you may be encouraged to increase contributions to retirement accounts or donate to charity to drive down your tax bill.