The 17th of May is just around the corner, and accountants all over the United States of America have a packed calendar till then. With the deadline fast approaching, you might want to get your financial affairs into order to avoid an IRS audit.
This article offers some basic information on federal tax brackets so you can calculate your taxes. We'll also go over how these brackets work using a simple example and talk about a few vital tax deductions to keep in mind before filing your return.
Tax brackets are nothing but divisions of income that are taxed differently. There are seven total divisions, taxed progressively at 10%, 12%, 22%, 24%, 32%, 35% and lastly, 37%. While the rates have remained the same since last year, the brackets have changed.
Here's a look at the revised brackets for the year 2021:
- 0-$9,950: 10% of taxable income
- $9,951-$40,525: $995+12% of the amount over $9.951
- $40,526-$86,375: $4,664+22% of the amount over $40,525
- $86,376-$164,925: $14,751+24% of the amount over $86,376
- $164,976-$209,425: $33,603+32% of the amount over $164,976
- $209,426-$523,600: $47,843+35% of the amount over $209,425
- $523,601 and above: $157,804.25+37% of the amount over $523,600
- $0-$19,900: 10% of taxable income
- $19,901-$81,050: $1,990+12% of the amount over $19,900
- $81,051-$172,750: $9,328+22% of the amount over $81,050
- $172,751-$329,850: $29,502+24% of the amount over $172,750
- $329,851-$418,850: $67,206+32% of the amount over $329,850
- $418,851-$628,300: $95,686+35% of the amount over $418,850
- $628,301 and above: $168,993.50+37% of the amount over $628,300
Head of household (HOH) is a filing status that an unmarried individual can file their taxes under, given that they qualify for the same. The criteria for being considered an HOH is:
- The HOH must be an unmarried (either single or divorced) individual
- The HOH must be covering more than half of the support and housing costs of a dependent qualifying person, which could either be a parent or a child of theirs
The benefit of filing taxes under HOH is that it makes one eligible for higher standard deductions and lower tax rates vis-a-vis filing it as single, or separately, if married.
- $0-$14,200: 10% of taxable income
- $14,201-$54,200: $1,420+12% of the amount over $14,200
- $54,201-$86,350: $6,220+22% of the amount over $54,200
- $86,351-$164,900: $13,293+24% of the amount over $86,350
- $164,901-$209,400: $32,145+32% of the amount over $164,900
- $209,401-$523,600: $46,385+35% of the amount over $209,400
- $523,601 and above: $156,355+37% of the amount over $523,600
Just because you raked in a total income of $90,000 this year does not mean that you straightaway owe 24% of your income to the government. The US uses a progressive tax regime; that is, people with higher incomes pay higher taxes, but in reality, the total amount of tax they pay is much lower than the bracket they fall into.
Tax brackets are nothing but divisions in your income. Every division is taxed differently. As the divisions rise (i.e., as you start earning more), the total tax accrued to the government rises. An example would make things clearer.
Thomas is a local musician and has earned a total of $50,000 in a year. Assuming that he's single, we'd conclude that Thomas owes 22% of his income to the government. But that is not so.
Thomas's income can be sliced into three divisions, and each accrues its own tax rate. Let's see how:
- From $0-$9950, Thomas owes 10%, i.e., $995.
- From $9,951 to $40,525, the tax rate is 12%, so it makes $3,669
- Finally, from $40,526 to $50,000, Thomas will be taxed 22% which makes $2,084.
The total of these three figures is $6,748, which happens to be about 13% of Thomas's total income of $50,000 instead of 22% as per the bracket. Herein comes the concept of the marginal tax rate.
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The tax paid on the marginal dollar, that is, an additional dollar to your income, is termed the marginal tax rate. In the previous example, Thomas's marginal tax rate was 22% because the last division of his income fell into the 22% tax bracket.
To calculate your tax liability using the given IRS tax brackets, you only need to know:
- Your total taxable income after all the applicable deductions
- The marital status you're filing your tax return under
The rest remains as per the example: Divide your taxable income into chunks based on the tax bracket divisions, and find out the total amount you owe by calculating the tax liability under each division and adding them.
Federal tax brackets are revised every year, primarily to account for inflation. To avoid what is called "bracket creep" (wherein taxpayers "creep" into a higher bracket on account of inflation), the adjustment of brackets is necessary.
Inflation is the percentage increase in the general price level in a year. There are various methods of calculating inflation, but the one used to adjust tax brackets is the Chained Consumer Price Index (C-CPI).
Mild annual inflation has been the norm in the USA, and hence, tax brackets slowly move upwards. There's a 0.76% to 1.00% shift in the upward direction in the various brackets in 2021 compared to 2020.
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Adjusting tax brackets is just one way for the IRS to address inflation and prevent the "bracket creep" phenomenon. The other crucial method used by the IRS is to provide certain deductions and tax breaks to taxpayers.
Wherever applicable, these tax deductions can be used to lower the total taxable income. Some of the most important ones are:
This is an amount you can straightaway deduct from your taxable income. The standard deduction rates for 2021 are:
- $12,550 for single and separately filing married taxpayer (up $150 from last year)
- $25,100 for jointly filing married taxpayers (up $300 from 2020)
- $18,800 for HOH (up $150 from 2020)
While short-term capital gains are taxed at the same rate as ordinary taxable income, long-term capital gains are taxed at a significantly lower level.
The criteria for any gain to be considered long-term is that the asset realized for that particular gain must've been held by the individual for more than one year.
For instance, a car bought and sold at a profit within a year by Thomas would be taxed as a short-term gain. But the gains from selling a signed Jimi Hendrix guitar after 5 years of being held by Thomas would be taxed as long-term gains.
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In the 1960s, the government implemented the Alternative Minimum Tax (AMT) regime, parallel to the existing tax regime, to prevent high-income individuals from evading their tax obligations to the government.
The AMT is levied at two rates: 26% and 28%. High-income individuals have to calculate their tax obligations twice, once under the normal tax rate and then in accordance with the AMT tax rates. The taxpayer then needs to pay the higher of the two estimates.
The AMT allows significant deductions for lower and middle-income groups while these deductions phase out as they reach the high-income individuals' bracket.
- The AMT deductions for unmarried individuals separately filing married individuals are $73,600 and $114,600, respectively.
- The AMT deduction phase-out threshold for 2021 is $523,600 for single individuals and $1,047,200 for married individuals filing separately.
Now that you know the federal tax brackets for 2021 and the way they work, you're all set to file your taxes!
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