Federal Tax Brackets, Marginal Tax Rate, and Effective Tax Rate — How Do They Work?

By Pinyo, on July 27, 2009

In this article, I want to go through a few basic tax concepts that include Tax Brackets, Marginal Tax Rate, and Effective Tax Rate. Due to uniqueness of individual States, we will focus our attention to the Federal Income Tax System and the same concepts can be generally applied at the individual State Income Tax level.

In the United States, we have a progressive tax system where people who earn more money generally pay more. There are six brackets, and the 2009 federal income tax brackets are as follows:

• 10% for the first $8,350 earned,
• 15% between $8,250 to $33,950,
• 25% between $33,950 and $82,250,
• 28% between $82,250 to $171,550,
• 33% between $171,550 and $372,950, and
• 35% above $372,950.

Marginal Tax Rate

One of the biggest misconceptions is that your entire income will be taxed at your bracket tax rate. For example, if you make $100,000, you have to pay 28% or $28,000. In fact, that’s not the case at all. Suppose your taxable income (after deductions and exemptions) is exactly $100,000 and your status is Single; then your tax would be calculated like this:

The $100,000 taxable income puts you in the 28% marginal tax rate bracket, but this only applies to income above $82,250. Income below that amount is taxed at the appropriate tax rate as per above chart.

When we talking about tax deduction, i.e., IRA contribution or charitable donation, we often talk about reducing our tax burden at the highest tax bracket. For example, “My $5,000 IRA contribution would cut my taxable income by $1,250 at my 25% marginal tax rate.”

Effective Tax Rate

Effective tax rate, or your actual tax rate, is simple the amount you are paying to the government as a percentage of your taxable income. In the example above, your effective tax rate is 21.72% ($21,720 divided by $100,000). Comparing 2008 tax rates, you are paying $258 less tax in 2009 for the same income.

Since these tax brackets are marginal, meaning that the rate is applied for each bracket before moving on to the next bracket. This means that your effective tax rate will always be less than your marginal tax rate — the percentage listed in the highest bracket.

I hope this article helps you improve your understanding of our tax system, specifically, Tax Brackets, Marginal Tax Rate, and Effective Tax Rate.

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Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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