If you’re an investor, knowing your tax bracket opens up a number of planning opportunities that can decrease your tax liability and increase your investment returns. Investing based on your tax bracket is something that good CPAs and financial advisors, including Betterment, do for customers.
Because the IRS taxes different components of investment income (e.g., dividends, capital gains, retirement withdrawals) in different ways depending on your tax bracket, knowing your tax bracket is an important part of optimizing your investment strategy.
In this article, I’ll show how you to estimate your tax bracket and begin making more strategic decisions about your investments with regards to your income taxes.
First, What is a Tax Bracket?
In the United States, federal income tax follows what policy experts call a progressive tax system. This means that people with higher incomes are generally subject to a higher tax rate than people with lower incomes. Currently there are seven different tax brackets, ranging from 10% up to 39.6%. Below are the 2017 Federal tax brackets if you are single or married filing jointly.
2017 Federal Tax Brackets
|Taxable Income Bracket: Filing as Single||Taxable Income Bracket: Filing as Married, Filing Jointly||Tax Rate|
|$0 to $9,325||$0 to $18,650||10%|
|$9,326 to $37,950||$18,651 to $75,900||15%|
|$37,950 to $91,900||$75,900 to $153,100||25%|
|$91,900 to $191,650||$153,101 to $233,350||28%|
|$191,650 to $416,700||$233,350 to $416,700||33%|
|$416,700 to $418,400||$416,700 to $470,700||35%|
|$418,400 or more||$470,701 or more||39.6%|
So, if you are single and have taxable income of $75,000 this year, you fall into the 25% tax bracket. However, that does not mean that all $75,000 of your income will be taxed at 25%. Instead, tax brackets apply to each portion of your income, building up like a staircase. Here’s a visual to help explain.
U.S. Federal Tax Brackets for Single Filers
If you are a single individual with a taxable income of $75,000, the first $9,325 of your income will be taxed at 10%, then dollars $9,326 – $37,950 will be taxed at 15%, and dollars $37,951 – $75,000 will be taxed at 25%. If your taxable income were to grow, then dollars $75,000-91,900 would still be taxed at 25%, but after that, the dollars would be taxed at higher tax rates.
Filing status (single, married, head of household, etc.) also affects your tax bracket. You can find the tax brackets for each filing status here.
How Difficult is it to Estimate My Tax Bracket?
Luckily, estimating your tax bracket is much easier than actually calculating your exact taxes, because U.S. tax brackets are fairly wide. Just look at the 25% tax bracket. If you are filing as single, any income between $37,950 and $91,900 falls within that same tax bracket. That’s a big margin of error for making an estimate.
The wide tax brackets allow you to estimate your tax bracket fairly accurately even at the start of the year, before you know how big your bonus will be, or how much you will donate to charity. Of course, the more detailed you are in calculating your tax bracket, the more accurate your estimate will be. And if you are near the cutoff between one bracket and the next, you will want to be as precise as possible.
How Do I Estimate My Tax Bracket?
Estimating your tax bracket requires three main pieces of information:
- Your estimated annual income
- Tax deductions you expect to file for
- Personal and dependent exemptions
These are the same pieces of information you or your accountant deals with every year when you file your taxes. So, If your personal situation has not changed very much from last year, the easiest way to estimate your tax bracket is to look at your last year’s tax return.
Estimating Your Tax Bracket with Last Year’s Tax Return
If you expect your situation to be roughly similar to last year, then open up last year’s tax return. If you review Form 1040, you can see your taxable income on Page 2, Line 43, titled “Taxable Income.” As long as you don’t have any major changes in your income or personal situation this year, you can use that number as an estimate to find the appropriate tax bracket on the table above (or the full set of tables here provided by the Tax Foundation).
Estimating Your Tax Bracket by Predicting Income, Deductions, and Exemptions
Estimating your bracket requires a bit more work if your personal situation has changed from last year. For example, if you got married, changed jobs, had a child or bought a house, those, and many more factors, can all affect your tax bracket.
It’s important to point out that your taxable income, the number you need to estimate your tax bracket, is not the same as your gross income. The IRS generally allows you to reduce your gross income through various deductions and exemptions, before arriving at your taxable income.
When Betterment calculates your estimated tax bracket, we use the three factors above to arrive at your estimated taxable income. You can use the same process.
1. Add up your Income.
Add up your income from all expected sources for the year. This includes salaries, bonuses, interest, business income, pensions, dividends and more. If you’re married, don’t forget to include your spouse’s income sources.
2. Subtract Your Deductions
Tax deductions reduce your taxable income. Common examples include mortgage interest, property taxes and charity, but you can find a full list on Schedule A – Itemized Deductions. If you don’t know your deductions, or don’t expect to have very many, simply subtract the Standard Deduction instead. For 2017, the standard deduction is $6,350 if you are single, and $12,700 if you are married filing jointly. By default, Betterment assumes you take the standard deduction. If you know your actual deductions will be significantly higher than the standard deduction, you should not use this assumption when estimating your bracket, and our default estimation will likely be inaccurate.
3. Subtract Your Exemptions
In addition to the deductions above, the IRS allows you to take a $4,050 deduction for you, your spouse (if applicable), and any dependent children you have. For example, if you are married and have one dependent child, you would have a $12,150 exemption amount (3 people * $4,050). Click here to read more about Personal and Dependent Exemptions. By default, Betterment assumes you will have one exemption if you are single and two exemptions if you are married. If you know you will have significantly more exemptions than that, you should not use these assumptions, and our default estimation will likely be inaccurate.
The number you arrive at after reducing your gross income by deductions and exemptions is called your taxable income. This is an estimate of the number that would go on line 43 of your 1010, and the number that determines your tax bracket. Look up this number on the appropriate tax bracket table and see where you land.
Again, this is only an estimate. There are countless other factors that can affect your marginal tax bracket such as exclusions, phaseouts and the alternative minimum tax. But for planning purposes, this estimation is more than sufficient for most investors. If you have reason to think you need a more detailed calculation to help formulate your financial plan for the year, you can consult with a tax professional.
How Can I Use My Tax Bracket to Optimize My Investment Options?
Now that you have an estimate of your tax bracket, you can use that information in many aspects of your financial plan. Here are a few ways that Betterment uses a tax bracket estimate to give you better, more personalized advice.
- Tax-Loss Harvesting: This is a powerful strategy that seeks to use the ups/downs of your investments to save you taxes. However, it typically only makes sense if you are in the 25% tax bracket or higher. For those in the 10% & 15% tax brackets, capital gains are taxed differently, which could make this strategy not beneficial.
- Tax-Coordinated Portfolio: This strategy reshuffles which investments you hold in which accounts to try to boost your after-tax returns. For the same reasons listed above, if you are in the 10% or 15% tax bracket, the benefits of this strategy are reduced significantly.
- Traditional vs. Roth Contributions: Choosing the proper retirement account to contribute to can also save you taxes both now and throughout your lifetime.
Generally, if you expect to be in a higher tax bracket in the future, Roth accounts are best. If you expect to be in a lower tax bracket in the future, Traditional accounts are best. That’s why our Retireguide™ tool estimates your current tax bracket, and where we expect you to be in the future, and uses that information to recommend which retirement accounts make the most sense for you.
In addition to these strategies, Betterment’s team of financial experts can help you with even more complex strategies such as Roth conversions, estimating taxes from moving outside investments to Betterment and structuring tax-efficient withdrawals during retirement.
Tax optimization is a critical part to your overall financial success, and knowing your tax bracket is a fundamental step toward optimizing your investment decisions. That’s why Betterment uses estimates of your bracket to recommend strategies tailored specifically to you. It’s just one way we partner with you to help maximize your money.
Betterment is not a tax advisor, nor should any information herein be considered tax advice. Please consult a tax professional.