You've heard it before, chatting at a cocktail party or even just in casual conversation with a business associate: What's your tax bracket?

What ... that hasn't happened to you? You need to party with more accountants. (On second thought, perhaps not.) Nevertheless, it's important that you know the truth about tax brackets, one of the most misunderstood aspects of taxes.

When people speak about their tax bracket or tax rate, they're generally referring to their "marginal" tax rate -- the rate at which their last dollar of taxable income is taxed. It's the maximum rate you're paying on any (not all) of your dollars of taxable income. For 2005, marginal tax rates were 10%, 15%, 25%, 28%, 33%, and 35%.

Your marginal tax rate only deals with the specific tax on your income. You may have to pay other taxes as well, such as self-employment taxes, the alternative minimum tax, and even penalty taxes on retirement-plan distributions. You can also benefit from credits, including the child tax credit, the dependent-care credit, or the 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 you're being taxed for all of your dollars.

The effective tax rate is simply your total tax obligation, including your income tax and any other additional taxes and/or credits, divided by your total taxable income. If you're self-employed, it's very possible that your effective tax rate could be much higher than your marginal rate, since you'll be paying the self-employment tax in addition to your normal income tax.

An example
Louie is single. In 2005, if he has taxable income of $7,300 or less, his marginal tax rate will be 10%. But if his taxable income climbs to between $7,301 and $29,700, his marginal tax rate will be 15%. And if his taxable income climbs to between $29,701 and $71,950, his marginal tax rate will be 25%. See how it works? So if Louie has taxable income of $31,800, the first $7,300 of his taxable income would be taxed at 10% (resulting in a tax liability of $730), the next $22,400 would be taxed at 15% (resulting in a tax liability of $3,360), and the remaining $2,100 would be taxed at 25% (yielding an additional liability of $525). Add those sums together, and you get Louie's total tax liability: $4,615.

When looking at the "big picture," you should compute your "effective" tax rate. This is simply your total tax liability divided by your taxable income. In the example above, while Louie's marginal tax bracket is 25%, his effective tax bracket is only 14.5% ($4,615 divided by $31,800 equals 0.145). The effective rate tells Louie that most of his income is being taxed at the lower 10% and 15% brackets, and only a small portion is being taxed at the next (25%) bracket.

So, to summarize Louie's tax situation:

  • Louie's marginal tax rate: 25%.
  • Louie's effective tax rate: 14.5%.
  • Most of his dollars were taxed at the lower 10% and 15% tax rates.
  • His remaining dollars were taxed at 25%.

How to find yours
Determining your marginal and effective tax brackets is not too difficult. If you're looking for your marginal bracket, simply turn to your 2005 tax return. Find the number located on line 43 if you filed Form 1040, line 27 if you filed Form 1040A, or line 6 if you filed Form 1040EZ.

Next, see where that number falls in the 2005 IRS tax tables. Don't forget to make sure to read the correct table based upon your filing status. (In other words, don't use the married tables to find your marginal tax bracket if you're actually single.) That will give you your marginal tax bracket, and tell you at what rate your next dollar of income will be taxed. It'll also allow you to see how close you might be to your next bracket.

If you're looking for your effective tax rate, it's almost as simple. Grab your 2005 tax return and make the following computations:

  • If you filed Form 1040, divide the amount on line 63 by the amount on line 43.
  • If you filed Form 1040A, divide the amount on line 38 by the amount on line 27.
  • If you filed Form 1040EZ, divide the amount on line 10 by the amount on line 6.

Once you do that division, you'll arrive at your effective tax rate, which will give you a good idea of where most of your income is being taxed.

Remember that you are using historical data (your 2005 tax return) to arrive at your marginal and effective brackets. If your income, deductions, and credits will remain similar in 2006, it's likely that your brackets will also remain similar. But if you expect a large increase or decrease in your income for 2006, you might want to re-check your bracket by using the information that you have at your disposal, along with the 2006 tax rate schedules.

Why you should care
If you are 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? For more strategies, check out our series on mid-year tax planning tips.

Everybody should know how to arrive at his or her tax bracket, and use it to its maximum advantage. It's an important number that you'll need to know before you make any tax-based decisions. Make sure you know yours!

When he's not dealing with tax issues, Fool contributor 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.