Tax Rates & Brackets

Tax Rates & Brackets 
"What's my tax bracket?" is a very important –and commonly asked– question.  First, it lets you know how much tax you must pay the government, and second, it affects how much after-tax savings certain deductions can generate, as well as how much after-tax return certain investments generate, under current rules.
In actual fact, there are two important tax rates for everyone:
• Marginal Tax Rate and 
• Effective Tax Rate (sometimes called "Overall Tax Rate").

Marginal Tax Rate
This rate is very important for tax planning purposes.  In effect, it is the tax rate you pay on the last dollar of net taxable income, hence the term "marginal."  Under our current tax laws, there are several tax brackets; the more money you make, the higher the tax for that portion –or bracket– of money.  For instance, a single individual with a taxable income of $400,000 would pay federal tax as follows:  10% on first $8,500, 15% on the first $26,000, 25% on the next $49,100, 28% on the next $90,800, 33% on the next $204,750 and 35% on the remaining $20,850, based on the 2012 tax rate schedules.

Thus, in this example,  the marginal rate would be 35%, and the taxpayer would pay 35 cents on every extra dollar earned above the $379,150 level already being taxed.  It also means this taxpayer would save 35 cents on every extra dollar of tax deductions at this level.  Examples of these allowable federal deductions are such items as interest expense, donations, taxes, medical, and miscellaneous business expenses, to name a few.  Taxpayers who also have deductions in such areas as rental property, capital losses, retirement plan deductions, and businesses of their own follow the same pattern.

Finally, this marginal rate is important in evaluating the true return on different types of investments.  By analyzing the gross income from the investment vs. the actual, after-tax yield, a "common denominator" can be found among various investments.  So, if the taxpayer in the example we used made an extra investment that yielded 10%, the actual, after-tax yield on this from a marginal tax rate standpoint would be 10% less the 35% tax, or 6.5%.

Let's use dollars to make the conceptualization easier.  Assume you make an investment that costs $10,000 and returns $1,000 (10%) in taxable income.  If your marginal tax rate is 35%, then $350 must be paid in taxes, leaving $650, or 6.5%.

Again, the same type of analysis applies to state taxes paid on a marginal basis.  This becomes especially important from an after-tax analysis in comparing taxable vs tax-free investments such as municipal bonds, or U.S. obligations such as treasuries.

In fact, the state marginal tax rate can be defined even more technically when you assume that state income taxes will be deductible on the federal tax return.  In this case, the state taxes are actually less because of the federal tax savings due to their deductibility.  As an example, if your state marginal tax rate were 4%, and your federal marginal tax rate were 35%, than the actual state, after-federal-tax marginal rate would be 3.65% which is the 4% less the federal tax savings of 35 cents on the dollar of deductions.

As you can see, the higher your income, the higher the marginal tax rate, and the more important this after-tax analysis becomes when it concerns your deductions, or your investments.

Effective Tax Rate (sometimes called "Overall Tax Rate")
This is exactly as it sounds; it's an average figure based on the total amount of tax you pay divided by your gross taxable income.  Thus, if you paid $5,000 in federal taxes, and your gross taxable income was $33,400 as a married filer, your Effective Tax Rate ("Overall Tax Rate") would be 15%.  In effect, you paid 15% of your gross taxable income to the federal government.  So, everything else being equal, you could budget that amount as your reserve for federal taxes.

The same type of analysis applies for state income taxes paid.  If your state tax amounted to $1,000 in the above example, your state Effective Tax Rate ("Overall Tax Rate") would be 3% before allowance for federal deductibility of these state taxes.

The effective tax rate is often a more accurate representation of a taxpayer's tax liability than its marginal tax rate.   Two companies that are in the same marginal tax bracket, for example, may end up with different effective tax rates depending on their earnings.  This occurs particularly with a progressive, or tiered, tax system, where different levels of income are taxed at different rates. Your effective tax rate is the rate you actually pay on all of your taxable income. You find your annual effective rate by dividing total tax you paid in the year by your taxable income for the year.  Your effective rate will always be lower than your marginal tax rate, which is the rate you pay on the income that falls into the highest tax bracket you reach.

For example, if you file your federal tax return as a single taxpayer, had taxable income of $75,000, and paid $12, 510 in federal income taxes, your federal marginal tax rate would be 28% but your effective rate would be 16.7%. That lower rate reflects the fact that you paid tax on portions of your income at the 10%, 15%, and 25% rates, as well as the final portion at 28%.  

Under progressive tax systems, one pays different rates for different amounts in income.  For example, one may pay 10% for the first $10,000 of income and 25% for all additional income.  In practice this means that one would pay somewhere between 10% and 25%. One calculates the effective tax rate simply by taking the total tax liability, dividing by one's taxable income and multiplying by 100.

Suppose one makes $20,000 in a year and is taxed under the above system. This person pays $1,000 (10%) of the first $10,000 and $2,500 (25%) of the second $10,000. The total tax liability is $3,500, which when divided by the $20,000 of income and multiplied 100, is found to have an effective tax rate of 17.5%.

Reference: Practice Enhancers, Able & Co.,  Farlex Financial Dictionary, Dictionary of Financial Terms