How IRS Tax Brackets Work

Federal income tax rates are determined by your filing status and your taxable income for the year – your adjusted gross income minus either your standard deduction or allowed itemized deductions. The tax rate increases progressively the more you earn and is divided into income tax brackets. There are seven tax rates ranging from 10% to 37% as of 2020.

It’s important to note you only have to pay the tax rate on the amount your taxable income falls into for each tax bracket. This is what’s known as ‘progressive taxation’ and can confuse a lot of people but an example can help illustrate how this works.

Let’s say your filing status is Head of Household and your taxable income is $62,116 and you used the 2020 tax brackets and rates.

Here is how your income would be taxed:

The first $14,100 would be taxed at 10%. 
Taxable income from $14,101 to $53,700 would be taxed at 12%.
And the taxable income from $53,701 to $62,116 would be taxed at 22%.

$14,100 taxed at 10% = $1410
$39,599 taxed at 12% = $4751.88
$8415 taxed at 22% = $1851.30

Grand total = $8013.18. That’s $1410 + $4751.88 + $1851.30.  

You would use a total of 3 different rates because your income fell into 3 different tax brackets. You would add them all up to find your total income tax owed. It is a common misunderstanding that all of your taxable income is taxed at the highest rate.

Making just enough to fall into a higher tax bracket means the amount you made just over a bracket will be taxed higher.  So if you made barely over one of the brackets it won’t equate to that much more in your grand total of taxes owed.

Reminder, your taxable income isn’t what you made for the year. Your taxable income is determined by finding your adjusted gross income and then subtracting either the standard deduction or itemized deductions (whichever you go with, whichever is more).

To determine your AGI (adjusted gross income) refer to the official IRS definition.

Retirement Plans for Self-Employed People

Self-employed have many of the same options to save for retirement on a tax-deferred basis as employees participating in company plans. The following information is from the IRS.

Simplified Employee Pension (SEP)

Establish the plan with a simple one-page form:

  1. complete
  2. open a SEP-IRA through a bank or other financial institution.

Set up the SEP plan for a year as late as the due date (including extensions) of your income tax return for that year.

401(k) plan
  • Make annual salary deferrals up to $19,500 in in 2021,  plus an additional $6,500 in 2021 if you’re 50 or older either on a pre-tax basis or as designated Roth contributions.
  • Contribute up to an additional 25% of your net earnings from self-employment for total contributions of $58,000 for 2021 ($57,000 (for 2020 and $56,000 for 2019), including salary deferrals.
  • Tailor your plan to allow access to your account balance through loans and hardship distributions.

A one-participant 401(k) plan is sometimes referred to as a “solo-401(k),” “individual 401(k)” or “uni-401(k).” It is generally the same as other 401(k) plans, but because there are no employees who work for the business, it is exempt from discrimination testing.

Savings Incentive Match Plan for Employees (SIMPLE IRA Plan)

You can put all your net earnings from self-employment in the plan: up to $13,500 in 2021 and in 2020 ($13,000 in 2019), plus an additional $3,000 if you’re 50 or older (in 2015 – 2021), plus either a 2% fixed contribution or a 3% matching contribution.

Establish the plan:

  1. complete
  2. open a SIMPLE IRA through a bank or another financial institution.
    • Set up a SIMPLE IRA plan at any time January 1 through October 1. If you became self-employed after October 1, you can set up a SIMPLE IRA plan for the year as soon as administratively feasible after your business starts.

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