How Do Tax Brackets Actually Work? 

Entrepreneurs trying to understand taxes for their business can be a confusing thing to go through. One fundamental aspect of our tax system is its progressive nature, which plays a significant role in determining how much individuals owe in taxes based on their income. 

In the United States, the tax system operates on a progressive basis, meaning that tax rates increase as income levels rise. This system is structured into tax brackets, each representing a range of taxable income subject to a specific tax rate. As individuals earn more income, they progress through these brackets, with higher rates applied to higher income levels.  

For instance, as of 2024, tax brackets for single filers range from 10% to 37%, with each bracket encompassing a different income range. Importantly, it's essential to understand that only the income falling within a particular bracket is taxed at the corresponding rate, not the not the entire pool of one's income. 

Navigating tax brackets effectively requires an understanding of how marginal tax rates function. Contrary to common misconceptions, moving into a higher tax bracket does not mean that all income is taxed at the higher rate. Instead, only the portion of income that exceeds the threshold of the higher bracket is subject to the increased rate.  

This progressive structure aims to achieve a balance between equitable distribution of the tax burden and incentivizing economic growth. In other words, the fair allocation of resources or assets among individuals or groups is based on principles of justice, fairness, and equality. 

By comprehending how tax brackets operate, you can utilize strategic tax planning techniques to optimize tax outcomes, minimize liabilities, and maximize after-tax income. 

What is a Progressive Tax System? 

At its core, a progressive tax system is designed to impose higher tax rates on individuals with higher incomes and lower rates on those with lower incomes. This system aims to distribute the tax burden more equitably, reflecting the principle of “ability to pay”. As entrepreneurs navigate the various stages of their business journey, from startup to expansion, understanding how progressive taxation impacts their financial decisions is crucial. 

Understanding Tax Brackets 

Tax brackets are the core of the progressive tax system, which has different income ranges. In the United States, these brackets are divided into several tiers, with each tier corresponding to a specific tax rate. Each bucket represents the range of income subject to different tax rates, higher income applies to higher rates.  

As entrepreneurs earn income, they progress through these tax brackets, with higher rates applied to higher income levels. 

For instance, as of 2024, the tax brackets for single filers are as follows: 

• 10% on income up to $11,600 
• 12% on income between $11,601 and $47,150 
• 22% on income between $47,151 and $100,525 
• 24% on income between $100,526 and $191,950 
• 32% on income between $191,951 and $243,725 
• 35% on income between $243,726 and $609,350 
• 37% on income over $365,600 

So, as you can see, if one is in the “32% tax bracket” only the income that is over $191,951 and under $243,725 would be taxed at 32%. Hopefully this clears up some confusion. 

What this means for Entrepreneurs 

For entrepreneurs, the progressive tax system introduces both opportunities and challenges. During the early stages of starting your business, when income is oftentimes lower, lower tax rates provide relief and enable reinvestment back into the business. However, as the business grows and generates higher profits, entrepreneurs may find themselves in higher tax brackets, leading to increased tax liabilities. 

Tax Planning Strategies 

Given the progressive nature of the tax system, entrepreneurs have the advantage of using various strategies to optimize their tax outcomes. 

Tax planning strategies serve as a guide for entrepreneurs navigating the intricate landscape of taxation. By proactively strategizing how to manage their tax liabilities, entrepreneurs can optimize their financial outcomes, preserve capital, and enhance profitability.  

Effective tax planning empowers entrepreneurs to make informed decisions at every stage of their business journey, from inception to expansion and beyond.  

By leveraging available deductions, deferral options, and entity structures, entrepreneurs can minimize tax burdens, freeing up resources to fuel business growth, and ultimately save for financial independence.  

In essence, tax planning strategies are not just about complying with tax laws; they are about strategically orchestrating financial decisions to maximize after-tax profits, be prepared for economic uncertainties, and pave the path toward long-term financial goals. 

 
Let’s dive into some of these tax strategies a little deeper. 

Income Deferral 

Income Deferral is timing income recognition to minimize tax liabilities in high-income years. Income deferral stands as a potent tax strategy within tools available to entrepreneurs.  

By strategically timing the recognition of income, entrepreneurs can effectively manage their tax liabilities, particularly during periods of heightened profitability. This tactic involves postponing the receipt of income to subsequent tax years, thereby deferring the associated tax obligations. Through income deferral, entrepreneurs can navigate progressive tax brackets more adeptly, potentially reducing their overall tax burden.  

This strategy not only provides immediate relief by lowering current tax liabilities but also offers the opportunity to reinvest deferred income tax savings into the business, promoting growth and strengthening financial resilience. 

However, it's essential to approach income deferral with careful consideration and thought. Every situation is different and it’s important to assess various factors, including the business's financial projections, anticipated tax implications, and regulatory constraints, to execute this strategy effectively.  

While income deferral can offer short-term benefits, it's imperative to strike a balance between deferring income and maintaining a steady cash flow to sustain business operations. With planning and strategic execution, income deferral can serve as a valuable tool for entrepreneurs seeking to optimize their tax outcomes and position their businesses for long-term success. 

Another form of “Income Deferral” one could consider is contributing to retirement accounts, such as IRAs and 401(k)s, could offer tax advantages and defer tax liabilities.  

Entrepreneurs can utilize the power of retirement accounts as a strategic tax planning tool, offering both immediate benefits and long-term financial security.  

By funneling a portion of your income into these accounts, entrepreneurs not only reduce their current taxable income but also position themselves for financial independence. Additionally, certain retirement account options, such as SEP-IRAs and Solo 401(k)s, cater specifically to self-employed individuals and small business owners, offering higher contribution limits and additional tax advantages. Be sure to seek a professional as these can vary per situation. 

Furthermore, retirement accounts afford entrepreneurs a valuable avenue for wealth accumulation and asset protection. Funds deposited into these accounts are typically shielded from creditors and legal judgments, providing a layer of security for entrepreneurs' retirement savings. By diligently contributing to retirement accounts throughout their entrepreneurial journey, individuals can build a robust financial nest egg while simultaneously optimizing their tax outcomes. Moreover, the disciplined savings habit cultivated through regular contributions to retirement accounts can instill financial discipline and prudence, fostering a mindset of long-term wealth accumulation and financial independence. 

Deductions 

Leveraging available deductions, such as business expenses and depreciation, to reduce taxable income, deductions represent a foundational pillar of tax strategy for entrepreneurs.  

Entrepreneurs can leverage an array of deductions, ranging from ordinary business expenses to depreciation allowances, to strategically lower their taxable income.  

Maximizing deductions requires a thorough understanding of tax laws and regulations, as well as diligent record-keeping practices. Entrepreneurs must ensure compliance with the IRS while also exploring avenues for legitimate deductions within the framework of the law.  

Staying informed of changes in tax laws and seeking professional guidance can help entrepreneurs identify new deduction opportunities and optimize their tax planning strategies. By strategically leveraging deductions, entrepreneurs can retain more of their hard-earned profits, saving for their long-term financial independence or reinvesting them back into their businesses to fuel growth and innovation. 

Entity Structure  

Choosing the appropriate business entity, such as a sole proprietorship, partnership, or corporation, can impact tax obligations. Entity structure serves as a pivotal tax strategy for entrepreneurs to optimize tax efficiency and minimize liabilities. It is important to carefully evaluate the tax advantages and disadvantages associated with each entity structure to select the most advantageous option for their unique circumstances. 

The flexibility built into certain entity structures enables entrepreneurs to adapt their tax strategies as their businesses evolve. For instance, the ability to elect to have your Sole-Proprietor LLC taxed as an S-Corp gives entrepreneurs greater control over tax planning and optimization. By aligning their entity structure and wages with their long-term business goals and financial objectives, business owners can leverage tax benefits of their chosen entity while mitigating potential risks and liabilities. 

Alleviate the Confusion 

Taxes as an entrepreneur can be daunting, but understanding the progressive tax system and implementing strategic tax planning strategies can alleviate a lot of the confusion and uncertainty.  

The progressive tax system, with its tiered tax brackets, ensures that individuals contribute to the tax burden according to their income levels. By grasping how tax brackets operate and applying tax planning techniques such as income deferral, deductions utilization and entity structure optimization, entrepreneurs can optimize their tax outcomes, minimize liabilities, and maximize after-tax income.  

These strategies serve as powerful tools for strengthening financial resilience, financial growth, and achieving your long-term financial goals. Ultimately, by staying informed, seeking professional guidance when necessary, and proactively managing your tax obligations, entrepreneurs can position themselves for financial independence and security. 

About the Author: Amanda Hanquist  

The Fit Financial is brought to you by Fit Wealth Advisors a partner of PlanGroup Financial. PlanGroup Financial is an investment adviser registered under the Investment Advisers Act of 1940. Registration as an investment adviser does not imply any level of skill or training. This presentation has been provided for informational purposes only and is not intended as legal or investment advice or a recommendation of any particular security or strategy. The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation.