If your income moves into a higher tax bracket, Uncle Sam will take a bigger slice of all of your taxable earnings, right? Wrong. If you want to get smarter about taxes -- and who doesn't? -- you'll need to understand the difference between marginal and effective tax rates.
Your marginal tax rate -- the figure usually associated with tax brackets -- is the top rate you're paying on your taxable income, and the rate at which your next dollar of income would be taxed. But it's not your overall tax rate.
Our tax system does feature a set of brackets, and you do pay an increasing tax rate as your income rises. However, only certain chunks of your income are subjected to each tax rate. Consider these tax brackets for single filers in 2006:
|
For taxable income between: |
The tax is: |
|---|---|
|
$0 and $7,550 |
10% of that sum |
|
$7,551 and $30,650 |
$755 plus 15% of the amount over $7,550 |
|
$30,651 and $74,200 |
$4,220 plus 25% of the amount over $30,650 |
|
$74,201 and $154,800 |
$15,107.50 plus 28% of the amount over $74,200 |
|
$154,801 and $336,550 |
$37,675.50 plus 33% of the amount over $154,800 |
|
$336,551 and up |
$97,653 plus 35% of the amount over $336,550. |
The marginal rates are in the right column -- 10%, 15%, 25%, 28%, 33%, and 35%.
How does it work? Imagine you make $7,550 a year. That puts you within the 10% bracket, so you'll pay 10% of that income in taxes -- $755 in all. Now, imagine you make just $100 more. Your new income of $7,650 has bumped you into the 15% bracket -- but you won't pay that 15% on everything you've made. Your first $7,550 of income is still taxed at 10%, but the additional $100 will be taxed at 15%, adding another $15 to your previous tax bill, for a total of $770.
This is a simple calculation, of course, so it doesn't include factors such as the alternative minimum tax, self-employment taxes, or various tax credits.
It's effective
Here's where the effective tax rate comes in. To see what your overall tax rate really is, take your total tax due and then divide it by your taxable income. In our example above, earning $7,650 gives you an effective tax rate of 10.1%, because your $770 tax bill is 10.1% of your total income.
A Foolish word of warning: For many people, the effective rate is lower than the marginal rate, but it can sometimes be higher.
Learn much more about taxes in our Tax Center, and get answers to your tax questions on our Tax Strategies discussion board.
Longtime Fool contributor Selena Maranjian is never marginal, and always effective.
