Understanding Tax Brackets

09/23/24 • 1 min

Understanding the difference between marginal tax rates and effective tax rates is crucial for accurate tax planning. The marginal tax rate is the rate applied to your last dollar of income, while the effective tax rate is the average rate you pay on all your income. A common misconception about taxes is that a 40% top tax rate means you’ll pay 40% of your taxable income in taxes. In reality, the U.S. uses a graduated income tax system, where your top, or marginal, tax rate only applies to the income within that bracket. For instance, many think a 24% tax rate on $100,000 of taxable income means $24,000 in taxes. However, the 24% rate only applies to the last $5,000 of income. The first $11,000 is taxed at 0%, the next $33,000 at 12%, and the following $50,000 at 22%. This results in approximately $17,000 in taxes. Your effective tax rate, which is the average rate you pay, would be 17%, even though your marginal rate is 24%. Note that these figures are for illustrative purposes only and your rates will vary.

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Tax Implications of Side Hustles

Having a side hustle is another term for being an independent contractor or self-employed. All income from a side hustle is taxable, whether it's part-time, temporary, not reported on traditional tax forms like W-2's or 1099's, or paid in cash, cryptocurrency, or barter. If you have a side hustle, track and report your income and expenses just like any other business. You must file a tax return if your net earnings from your side hustle exceed $400, even if you otherwise aren't required to file a return. As a self-employer person, you'll need to pay both income and self-employment taxes on your earnings. If you don't have an employer to withhold additional taxes, you might need to make quarterly estimated tax payments. The good news is you can deduct work-related expenses such as vehicle mileage, a portion of your cell phone bill, and possibly even home office costs. For more details on saving taxes on your side hustle, consult your CPA.

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Tax Benefits of Retirement Accounts

What is the best account to use for your retirement savings, a 401(k) or an Individual Retirement Account (IRA)? Each has pros and cons. With a 401(k), you can set aside more each year (up to $23,000 in 2024, or $30,500 if you’re over age 50). It’s easy for an individual to set up, as your employer typically handles deducting your contributions from your paycheck and depositing them into the account. There are no income limits, and often employers offer matching contributions to boost your savings. IRAs are a bit more flexible than 401(k)s. You can make contributions until the filing deadline (usually April 15 of next year), whereas 401(k) contributions generally must be made by December 31 of this year. You can contribute any type of earned income to an IRA, so you don’t have to rely on your employer to offer the plan. However, you are responsible for setting aside and making your contributions. The max contribution to an IRA is lower ($7,000 in 2024, or $8,000 if you’re 50 or older), and there are income limits that apply if you or your spouse are also covered by an employer plan. There are also many other types of retirement plans to consider, especially if you're self-employed, such as SEPs and SIMPLEs. It’s best to confer with your advisers to determine which plans are best for your circumstances.