Your federal marginal income tax rate is the rate of tax that you pay on your last, or so-called highest, dollars of income (see Table 4-1). Your taxable income is the income that is left after taking allowed deductions on your return.
TABLE 4-1 2021 Federal Income Tax Rates for Single and Married Households Filing Jointly
| Federal Income Tax Rate | Singles Taxable Income | Married Filing Jointly Taxable Income |
|---|---|---|
| 10% | Up to $9,950 | Up to $19,900 |
| 12% | $9,951 to $40,525 | $19,901 to $81,050 |
| 22% | $40,526 to $86,375 | $81,051 to $172,750 |
| 24% | $86,376 to $164,925 | $172,751 to $329,850 |
| 32% | $164,926 to $209,425 | $329,851 to $418,850 |
| 35% | $209,426 to $523,600 | $418,851 to $628,300 |
| 37% | Over $523,600 | Over $628,300 |
Your actual marginal tax rate includes state income taxes if your state levies an income tax. Though this chapter focuses upon the federal income tax system and strategies to reduce those taxes, most of what is discussed also helps you reduce your state income taxes, which the vast majority of states levy. Each state income tax system is unique, so covering them all here is impossible. All but eight states — Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming — impose a state income tax. (New Hampshire has only a state income tax on dividend and interest investment income.)
How much you could reduce your taxes if you contribute more money to retirement accounts
How much you would pay in additional taxes on extra income you could earn from working more
How much you could reduce your taxable income if you use investments that produce tax-free income (which may make sense only if you’re in a higher tax bracket — more on this later in the chapter)
Highlighting the Tax Cuts and Jobs Act bill
The Tax Cuts and Jobs Act bill took effect in 2018, and most people and small businesses enjoyed lower federal income taxes as a result. Most federal income tax bracket rates were reduced by 2 to 3 percent.
Here are some of the other major changes in the tax bill:
Increased Child Tax Credit: The child tax credit, which previously stood at $1,000 per child under the age of 17, was increased to $2,000 per child, and up to $1,400 of that will be refundable for taxpayers not otherwise owing federal income tax. Also, the incomes at which this credit starts phasing out rises from $110,000 for married couples to $400,000, and from $75,000 for non-married filers to $200,000.
State and local taxes deduction capped at $10,000: This also includes property taxes on your home. For homeowners in high cost of living areas with high state income taxes (for example, metro areas such as San Francisco, Los Angeles, New York, Washington D.C.), this cap poses a modest or even significant negative change. Because state and local taxes are itemized deductions, only being able to take up to $10,000 (previously unlimited) for them may cause some taxpayers to no longer be able to itemize. Also, by reducing the tax benefits of home ownership (see also the next item), this change effectively raises the cost of home ownership, especially in high-cost and highly taxed areas.
Mortgage-interest deduction for both primary and second homes capped at $750,000 borrowed: This represents a modest reduction from the previous $1,000,000 limit on mortgage indebtedness deductibility.
The Tax Cuts and Jobs Act slashed the corporate income tax rate to 21 percent, which represented a 40 percent reduction. At 35 percent, the U.S. previously had one of the highest corporate income tax rates in the world before 2018.
Another change simplified the corporate tax rules and deductions, including the elimination of the corporate alternative minimum tax, and some loopholes closed. The U.S. also moved to a “territorial” tax structure, whereby U.S. companies no longer pay a penalty to bring their overseas profits back home. The immediate impact of this change was to enable U.S. corporations to bring back to the U.S. more than $2 trillion being kept overseas to avoid excessive taxation.
You will note that at higher levels of income, the individual income tax rates begin to exceed the 21 percent corporate tax rate. Seeing this can help you to better understand the next point as to why pass-through entities are being granted a special tax deduction on their profits.
In redesigning the tax code, Congress rightfully realized that the many small businesses that operate as so-called pass-through entities would be subjected to higher federal income tax rates compared with the newer 21 percent corporate income tax rate. To address this concern, Congress provided a 20 percent deduction for those businesses. So, for example, if your sole proprietorship netted you $70,000 in 2021 as a single taxpayer, that would push you into the 22 percent federal income tax bracket. But you get to deduct 20 percent of that $70,000 of income (or $14,000), so you would only owe federal income tax on the remaining $56,000 ($70,000 – $14,000).
Another way to look at this is that the business would only pay taxes on 80 percent of their profits and would be in the 22 percent federal income tax bracket. This deduction effectively reduces the 22 percent tax bracket to 17.6 percent.
This is a major change, which not surprisingly, has made small business owners exceedingly optimistic about being able to grow their businesses. In fact, in a 2018 survey of small business owners conducted by the nonprofit National Federation of Independent Business just after the tax bill was passed and signed into law, a record percentage of those surveyed (covering the survey’s 45-year history) expressed optimism about it being a good time to expand their businesses.
This 20 percent pass-through deduction gets phased out for service business owners (such as lawyers, doctors, real estate agents, consultants, and so forth) at single taxpayer incomes above $157,500 (up to $207,500) and for married couples filing jointly incomes over $315,000 (up to $415,000). For other