Understanding the basics of the United States Progressive Income Tax Rates is a critical piece of information when formulating any type of short-term and long-term financial plan. Many folks have the misconception that the higher your income, the more you will pay in income tax thus actually lowering your take home (net) pay. That’s not the case. For example: If I was earning $80,000 a year at my job and got a raise to $90,000, the $90,000 income surpasses the threshold for a 24% tax bracket. However, not all of the $90,000 will be taxed at 24%. The US utilizes a progressive taxation scale. Simply put, not all of your income is taxed at the same rate. The IRS changes the “Income Tax Brackets” yearly.
Below is a chart displaying the current 2020 Income Tax rates for single and Married Filing Jointly.
2020 Tax Brackets for Single/Married Filing Jointly
| Tax Rate | Taxable Income (Single) |
Taxable Income (Married Filing Jointly) |
|---|---|---|
| 10% | Up to $9,875 | Up to $19,750 |
| 12% | $9,876 to $40,125 | $19,751 to $80,250 |
| 22% | $40,126 to $85,525 | $80,251 to $171,050 |
| 24% | $85,526 to $163,300 | $171,051 to $326,600 |
| 32% | $163,301 to $207,350 | $326,601 to $414,700 |
| 35% | $207,351 to $518,400 | $414,701 to $622,050 |
| 37% | Over $518,400 | Over $622,050 |
Not getting overly complicated with allowable deductions, let’s use the $90,000 per year salary I mentioned above and do basic math for a single filer. Using that income, this is how you would calculate your taxes for the 2020 fiscal year. Using the charge above:
The 1st $9875 will be taxed @ 10%. That equals = $987.50
The next $30,249 (40125 – 9876) will be taxed @ 12%. That equals = $3,629.88
The next $45,399 (85525 – 40126) will be taxed @ 22%. That equals = $9,987.78
Finally, the remaining $4,474 (90000 – 85526) will be taxed @ 24%. That equals $1,073.76
Total tax bill for 2020 would be $15,678.92
The increase in income from $80,000 per year to $90,000 per year would represent an increase of $2,288.76. Many folks believe the the increase to $90,000 would move their entire income for the 22% tax bracket to the 24% tax brackets and result in a $21,600 tax bill, ouch! Fortunately, that’s not how this works.
Now remember, for the purpose of this illustration, I used simple math and didn’t get into allowable deductions. Deductions lower your taxable income in what’s known as your AGI (adjusted gross income). Understanding these tax thresholds and how to minimize the amount of income tax to be paid at the higher percentages by utilizing investment vehicles can make a huge difference in the amount of taxes you will be required to pay at years end. What investment vehicles am I referring too? Well, you have several options. I will discuss those options below.
401K/403B/457 – Employer based retirement plans are the first step in lowering your AGI (adjusted gross income). The employer based retirement plans provide pre-tax contributions into the investment plan of your choice if the employer provides such a plan. Because they are pre-tax (before taxes are applied), you can set aside up to $19,900 maximum for the 2020 calendar year. Why is this important? Let’s go back to the $90,000 income example. If I wanted to avoid paying the 24% tax on the amount over the $85,525, I could elect to defer $5,000 into my 401K thus staying below the $85,525 threshold and not paying 24% on the final $4,474.
What about if my employer does not provide a 401K? In this situation, the use of a Traditional IRA (individual retirement account) would be a suitable option. Traditional IRA annual contribution limits for 2020 are $6,000 for individuals under the age of 50. For individuals over the age of 50, the contribution limits are $7,000. Using a traditional IRA would provide the same benefits as the 401K/403B/457 employer based plans in the $90,000 example above. Offsetting $5,000 through the IRA would keep you below the $85,525 (24%) threshold.
A final option that can be utilized is an SEP IRA (Simple Employee Pension Plan). SEP are excellent vehicles for single business owner or small businesses. SEP IRA’s provide similar benefits as 401k/403b/457 as well as similar contribution limits of $19,900.
As you can see, it’s very important to understand taxation on your income in order to maximize your take home pay. Additionally, by taking advantage of available investment options such as 401k’s, traditional IRA’s or SEP IRA’s in order to lower your AGI will benefit your retirement portfolio in the long run.
If you would like a personalized financial needs analysis, which will include possible strategies as the one presented above, please contact me directly at louis@louisromero.com