In this article, I will explain a few basic tax concepts related to our Federal income tax system that include Tax Brackets, Marginal Tax Rate, and Effective Tax Rate. In the United States, we have a progressive tax system where people who earn more money generally pay more. There are six Federal tax brackets and the you can see the most up-to-date tax brackets here.
Note: The numbers in this section is based on 2009 tax brackets; however, the concept is applicable regardless.
One of the biggest misconceptions is that your entire income is 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 credits) is exactly $100,000 and your status is Single; then your tax would be calculated as follow:
|(||$8,350 minus||$0 )||x 10% =||$835.00|
|(||$33,950 minus||$8,350 )||x 15% =||$3,840.00|
|(||$82,250 minus||$33,950 )||x 25% =||$12,075.00|
|(||$100,000 minus||$82,250 )||x 28% =||$4970.00|
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, e.g., 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, or your actual tax rate, is simply 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).
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 better understand our tax system, specifically, tax brackets, marginal tax rate, and effective tax rate.