It probably comes up all the time, when you're chatting at a cocktail party or shooting the breeze with a business associate: What's your tax bracket?
What? That hasn't happened to you? You need to party with more accountants. But before you do, make sure you know the truth about tax brackets, one of taxation's most misunderstood aspects.
Marginally effective
When people speak about their tax bracket or tax rate, they're generally referring to their "marginal" tax rate. That's the rate at which your last dollar of taxable income is taxed, not the rate at which all your dollars are taxed. It's the maximum rate you're paying on any of your dollars of taxable income. For 2005, marginal tax rates are 10%, 15%, 25%, 28%, 33%, and 35%.
Your marginal tax rate only deals with the specific tax on your income. There are other taxes you may have to pay: self-employment taxes, the alternative minimum tax, maximum capital gains taxes, and even penalty taxes on retirement plan distributions. There are also credits you may benefit from, such as the child tax credit, the dependent care credit, or education credits. After this jumble of other taxes and credits, your marginal tax rate may lose a bit of its importance.
That's why you'll want to take a peek at your effective tax rate -- the average rate at which all your dollars are taxed. To figure this out, just take your total tax obligation (including your income tax and any other additional taxes and/or credits) and divide it by your total taxable income.
It's possible that your effective tax rate could be much higher than your marginal rate. For example, if you're self-employed, you could get hit with the self-employment tax in addition to your normal income tax. On the other hand, if you have a large long-term capital gain that gets taxed at the preferred 15% rate, you could end up with an effective tax rate lower than your marginal rate.
Let's break it down
Suppose you're single, and you've got a taxable income of $60,000 for 2005. The first $7,300 of that money falls in the lowest tax bracket, and will be taxed at 10%, for a total of $365. All the dollars you've made between $7,301 and $29,700 fall into the next bracket up; you'll pay 15% on them, adding another $3,360 to your tax bill. And from $29,701 on up (to a maximum of $71,950), you'll be paying 25% on each additional dollar, adding $7,575 to your debt to Uncle Sam. Since your total income falls between $29,701 and $71,950, you land in the 25% tax bracket -- your marginal tax rate -- with a total tax liability of $11,300.
However, take a moment to compute your effective tax rate. Divide that $11,300 by your $60,000 income, and you'll come up with 18.8%. That indicates that most of your income is being taxed at the lower 10% and 15% rates, and only a little of it falls under the heftier 25% burden.
Why should I care?
Everybody should know how to arrive at his or her tax bracket, and use it to its maximum advantage. It's an important number, and a number that you'll need to know before you make any tax-based decisions.
For example, if you're on the cusp of the next tax bracket, you'll want to defer income or find more deductions. Have you contributed as much as you can to your 401(k)? Given to charity? Steps like these can help keep you from paying extra when April 15 rolls around. For more strategies, check out the article on year-end planning tips.
When he's not dealing with tax issues, Roy Lewis is a motivational speaker who lives in a trailer down by the river. He understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.
