Image source: Flickr user Frankleleon.
As you complete your returns this tax season, you'll be able to see firsthand what tax bracket you were in during 2015. But many people get confused when they look at their actual tax liability and see that it seems to differ from the bracket they thought applied to them. Knowing what your tax bracket really means is useful in planning your taxes.
What tax brackets are
The U.S. tax system is progressive in nature, charging low tax rates for lower amounts of income and higher tax rates as income grows. Currently, there are seven tax brackets. The lowest-income taxpayers begin paying tax at a 10% rate. From there, intermediate rates of 15%, 25%, 28%, 33%, and 35% apply before reaching the top tax bracket of 39.6%. Depending on your filing status, different income thresholds mark where each tax bracket begins and ends.
What it means to be in a particular tax bracket is that the last dollar of your income was taxed at the rate corresponding to the bracket. For instance, if you're in the 25% bracket, then you paid $0.25 in tax for the last $1 of income that you earned for the year.
Why tax brackets aren't as big a deal as many people think
Note that the tax bracket rate applies only to the last income that you earn, not the entire income amount. Many taxpayers get scared when their income approaches the top of a tax bracket that they'll be kicked into the next-higher bracket, erroneously thinking that the higher rate will apply to every penny of their income. However, even if you're in the top tax bracket, you still get to enjoy the lower tax rates on the portions of your income that fell into the lower brackets.
As a result, your effective tax rate will almost always be lower than your marginal tax rate. For instance, if you're in the 15% tax bracket and you make exactly twice as much money as the top end of the 10% tax bracket, then your effective tax rate will be the average, or 12.5%. That doesn't change the fact that your marginal rate is still 15%.
Why it's good to know your tax bracket
For planning purposes, knowing your tax bracket is important in making decisions about income and deductions. The tax rate associated with your bracket will help you calculate how much extra tax you'll pay if your income goes up by a certain amount. It will also show you how much tax you'll be able to save if you take advantage of a tax deduction or reduce your income by a certain amount.
One caution in using this simple calculation is that it only holds true if the deduction or income in question doesn't push you into a different tax bracket. For instance, if you're in the 15% tax bracket but are only $100 away from being in the 25% tax bracket, then considering a move that will add $200 to your taxable income will result in additional tax liability of $40 -- $15 corresponding to 15% of the first $100, plus $25 from taxing the second $100 at 25%.
Finally, bear in mind that tax brackets are specific to your filing status. In particular, if your marital status changes, it can result in big changes to your tax bracket even if your income stays the same. Looking closely at tax brackets if you get married or divorced can be essential in avoiding big tax surprises.
The concept of the tax bracket is simple, but it has implications that many people don't understand. Knowing your tax bracket can give you the information you need to be smart in assessing your tax situation.
