When it comes to federal income taxes, many people believe that once their income surpasses a certain threshold, their entire income is taxed at the higher rate. This is a common tax misconception, but it’s important to understand how the system really works.
The federal income tax system is a marginal tax system, which operates more like a waterfall than a simple breakpoint.
What’s the difference?
- Breakpoint system: Think of this as an “all-or-nothing” approach, where once you hit a certain income level, the entire amount above that level is taxed at a higher rate. While this applies to some taxes (like Medicare IRMAA), it is not how your federal income tax works.
- Waterfall system: In reality, the U.S. tax system is designed to tax portions of your income at different rates as it flows through the various tax brackets. Each dollar you earn is taxed according to the bracket it falls into, not the whole amount at the highest rate. For example:
- If you’re in the 24% tax bracket, only the income within that bracket gets taxed at 24%, and the rest of your income falls into lower brackets with their respective rates.
Why does this matter?
Understanding that the tax system works like a waterfall is crucial for proper tax planning. The higher rates only apply to the income within that specific bracket, meaning you’re not paying a higher rate on all your income just because you crossed into a higher bracket.
Watch my video to dive deeper into this concept and uncover the truth about how your federal income taxes are calculated!
Disclosure:
The information provided in this article is for educational purposes only and should not be construed as financial advice. The examples and case study presented are hypothetical and intended to illustrate general retirement planning concepts. Individual results may vary based on a variety of factors, including but not limited to income, expenses, taxes, market performance, and personal financial circumstances.
While every effort has been made to ensure the accuracy of the information, it is important to consult with a qualified financial advisor to discuss your specific situation before making any financial decisions. Brooks Wealth Management is a registered investment advisor (RIA) and provides fiduciary financial planning services.
Past performance is not indicative of future results, and all investments carry risk, including the potential loss of principal.