Tax Brackets

By Jon Scott

In this article we will cover:

• Federal tax brackets—maximum bracket vs effective tax rate

• Capital gains brackets

• Social security tax

• Medicare tax

Picture this: you’ve just gotten your first paycheck in your life. You’ve been working an average of five hours a day at $25/hr for two weeks. Today is payday and you’re excited to get 1,750 dollars richer. To your surprise, your paycheck ended up being $1,369, about 22% smaller than what you were expecting. In order to understand where your money went, you have to understand one of the few certainties in this world: taxes.

Federal Tax Brackets

Federal income tax is the largest source of income for the United States government, and they are based on an individual/couple’s taxable income. Some common items that make up taxable income are salary, wages, tips, bonuses, employer-provided benefits, and interest from sold investments. Furthermore, a deductible is an expense that a business or taxpayer can deduct from their gross income to make their final taxable income. You can either claim the standard deductible based on your filing status, or you can fill out a list of individual deductible expenses.

Federal income tax is broken down into 10%, 12%, 22%, 24%, 32%, 35%, and 37% brackets, with the higher tax rates being associated with increased income. The following is a table of the 2022 tax year brackets based on your filing status:

A common misconception when it comes to tax brackets is assuming that the rate of your tax bracket is applied to your entire taxable income. In reality, you are taxed on the income within each threshold of a tax bracket at that tax bracket’s rate.

For example, say someone has a gross income of $100,000, is a single filer, and takes the standard deduction.

1. The standard deduction for single filers in 2021 was $12,950, so their taxable income is $87,050, putting them into the 22% tax bracket.

2. This means that the first $10,275 they make is taxed at 10%, the next $31,500 they make ($41,775 - $10,275) is taxed at 12%, and the next 45,275 ($87,050 - $41,775) is taxed at 22%, coming out to a total of $14,768 federal income tax.

3. This is a stark difference of your entire taxable income being taxed at 22%, which would be $19,151. Your effective tax rate is the weighted average of all the taxes you paid on your income, while marginal tax rate is the rate of the highest bracket your income falls under.

There are also state income taxes, but those vary on a state-by-state basis.

Capital Gains Tax

You also have to pay a special tax rate on the profits of investments you’ve sold in the last year, in the form of the capital gains tax. There are two forms of capital gains tax: short-term and long-term. Short-term capital gains are paid on investments that were sold after being held less than a year, and long-term capital gains are paid on investments that were sold after being held for more than a year. Like with other areas of taxes, capital gains tax rates generally increase with the amount of income you make. The short-term capital gains tax rate is the same as your income tax rate, while long-term capital gains is a reduced rate.

The following is a table of how your long-term capital gains are taxed in 2022 based on your total income:

Social Security Tax and Medicare Tax

The Social Security program is funded through a dedicated payroll tax of 6.2% of an employee’s income up to a taxable maximum of $147,000 (as of 2022) that both the employer and the employee pay, which is deducted automatically. If you are self-employed, this tax becomes 12.4%. This payroll tax made up 90.1% of Old Age and Survivor insurance and disability insurance in 2021.

The Medicare tax is deducted automatically from your paycheck as well and is used to fund Medicare Part A. The total is split among the employee and the employer, each paying a tax of 1.45% of the employee’s income. High income earners pay a slightly higher percentage and self-employed people pay this tax with their quarterly filings.

Now we can explain what happened in the introduction. Making $1,750 every two weeks would have an effective tax rate of 10.4%, which comes out to $182. At a state tax rate of 3.75%, which is $66, and then accounting for both Medicare and Social Security tax, the total amount taxed comes out to $381, making our take-home pay $1,369.

Key Takeaways

• There are many types of taxes worth noting, but four important ones everyone has to know about are federal income tax, capital gains tax, Medicare tax, and Social Security tax.

• Federal income tax is the government’s main source of income and the amount you are taxed depends on your income. Usually, you have to file your own taxes or have someone file them on your behalf.

• Capital gains tax comes in both short- and long-term forms, and it is levied on the profit of investments that you sell. Short-term capital gains tax occurs on investments you sold after owning for less than a year, and the rate is exactly the same as your income tax bracket. Long-term capital gains occurs on investments held for longer than a year, and it has a reduced rate.

• Social Security and Medicare tax are both deducted from your paycheck automatically, and they are 6.2% and 1.45%, respectively (assuming you are a W-2 employee). Your employer will also be taxed at the same amount you are.