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It's officially tax week, which for some Americans brings resounding applause because they know a federal refund is likely on the way. In an average year, the Internal Revenue Service sends refunds to approximately four in five taxpayers.
However, preparing our taxes can be a major challenge. This is partly because of the hassle of poring through countless receipts and digging through a year's worth of our income history. But the other component here is that tax knowledge is lacking among most Americans -- and who can blame them, with the U.S. tax code approaching 4 million words?
NerdWallet conducted a survey of 1,015 people across the U.S. in February 2015 asking 10 questions regarding basic personal finance topics; the average score turned out to be a paltry 51%. If this were school, Americans would have received a big fat "F" for their cumulative tax knowledge. And as we all know, if the consumer doesn't understand something, they won't be able to tax full advantage of it.
Understanding the 2016 federal income tax brackets Rather than tackle some of the complexities of tax credits and deductions today, I thought we'd examine one foundation of the federal tax system, which should come first and foremost when trying to understand your tax liability: federal income tax brackets. Specifically, we're going to be looking at the 2016 federal income tax brackets, which means we're looking at how your income will be taxed this year when you prepare your taxes 9-to-12 months from now.
Here are five important things you should know about 2016 federal income tax brackets.
1. There are seven progressive federal income tax brackets The first thing you'll want to know about the federal income tax brackets is that there are seven of them, and they're progressive based on the amount of taxable income you have, after taking deductions into account.
2016 Federal Income Tax Schedule
Table by author. Data source: IRS.
As you can see above, the more you make, the higher your likelihood of moving into a higher ordinary tax bracket.
However, it should be noted that your filing status can also greatly impact what federal income tax bracket you fall into. For instance, couples filing jointly can cumulatively earn up to $151,900 and still be taxed at a peak ordinary tax rate of 25%. By comparison, single filers move to a 28% ordinary income tax rate once they hit $91,150 in income.
2. The 2016 tax schedule is relatively unchanged compared to the 2015 tax scheduleEvery year the Internal Revenue Service uses the Consumer Price Index, which calculates the cost of a basket of goods and services in an effort to measure the inflation rate, to adjust income thresholds, deductions, and credits. The higher the rate of inflation, the more we'd expect income thresholds within the federal income tax brackets to increase. The lower the rate of inflation, the less the income thresholds will be affected.
2015 Federal Income Tax Schedule
Table by author. Data source: IRS.
As you can see from the 2015 federal income tax brackets above (which you can compared to the 2016 tax brackets in point one), there have been relatively minor adjustments higher in the income thresholds on a year-over-year basis, in according with our current low-inflation environment. While not a precise science, income thresholds have risen by about 0.5% year-over-year.
3. Your effective tax rate is usually lower than your peak ordinary tax rateA potential misconception with federal income taxes is that your entire income for the year is taxed at your peak ordinary income tax rate, which isn't the case. In reality, only money earned within a specific tax bracket is subject to a specific tax rate.
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For example, imagine your taxable income winds up being $50,000 in 2016. As a single filer this would mean your peak ordinary (or marginal) tax rate is 25%. But you won't owe 25% tax on all $50,000. Instead, you'll pay a 10% tax on each dollar earned between $1 and $9,275; then a 15% tax on each dollar earned between $9,276 and $37,650; and finally 25% on each dollar earned between $37,651 and $50,000. Added together, your tax works out to $8,271 with a taxable income of $50,000, or 16.5% of your taxable income. This 16.5% represents your effective tax rate relative to your taxable income.
4. Your peak ordinary tax rate may determine your capital gains and dividend taxThe federal income tax brackets may also determine how much you'll owe if you have capital gains or dividend income to report during 2016. Short-term gains from assets held for one year or less are taxed at your peak ordinary income tax rate. However, long-term gains held for one year and a day or longer achieve a special, lower tax rate.
Image source: Pictures of Money via Flickr.
As you can see in the 2016 federal income tax schedule under point one, taxpayers who fall into the peak ordinary tax rates of 10% or 15% are free and clear of federal income tax on capital gains held for more than a year and a day. Single filers, couples, and heads of household in the 25%, 28%, 33%, and even 35% tax brackets are only on the hook for a 15% tax rate on capital gains and dividends. Finally, the wealthiest taxpayers will owe 20% on long-term capital gains and dividends. Still, this is a nice drop from the 39.6% peak ordinary income tax rate, and a big reason why the rich keep getting richer.
5. State and federal income tax tables are usually differentFinally, keep in mind that the majority of states do require taxpayers to file state income tax returns, and that the tax rules and regulations of your state are very likely not the same as the federal income tax brackets. In fact, most states are even unique from one another in how they handle taxing residents and offering credits and deductions. In other words, you'll want to pay close attention to how your state handles income taxes and ensure you're using tax software or seeking professional assistance in order to avoid making an error.
The article 5 Things You Need to Know About 2016 Federal Income Tax Brackets originally appeared on Fool.com.
Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.
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