You've heard it before, during chats 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 2013 and 2014, marginal tax rates are 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%.
Your marginal tax rate deals only 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, your effective tax rate could very well be much higher than your marginal rate, since you'll be paying the self-employment tax in addition to your normal income tax.
Louie is single. In 2014, if he has taxable income of $9,075 or less, his marginal tax rate will be 10%. But if his taxable income climbs to between $9,076 and $36,900, his marginal tax rate will be 15%. And if his taxable income climbs to between $36,901 and $89,350, his marginal tax rate will be 25%. See how it works? So if Louie has taxable income of $40,000, the first $9,075 of his taxable income would be taxed at 10% (resulting in a tax liability of $907.50), the next $27,825 would be taxed at 15% (creating a tax liability of $4,173.75), and the remaining $3,100 would be taxed at 25% (yielding an additional liability of $775). Add those amounts together, and you get Louie's total tax liability: $5,856.25.
When looking at the big picture, you should compute your effective tax rate, which is simply your total tax liability divided by your taxable income. In Louie's example, while his marginal tax bracket is 25%, his effective tax bracket is between 14% and 15% ($5,856.25 divided by $40,000 equals 0.146). 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: 14.6%.
- 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 2013 return (or your 2012 return if you haven't done your 2013 taxes yet). 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 2013 IRS tax tables. Make sure you read the table that corresponds to your filing status. (In other words, don't use the "married" tables to find your marginal tax bracket if you're single.) That's how you'll find your marginal tax bracket. You'll also see at what rate your next dollar of income will be taxed, and you'll find out how close you might be to hitting the next bracket.
If you're looking for your effective tax rate, it's almost as simple. Grab your 2013 tax return and make the following computations:
- If you filed Form 1040, divide the amount on line 61 by the amount on line 43.
- If you filed Form 1040A, divide the amount on line 35 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're using historical data (your 2013 tax return) to arrive at your marginal and effective brackets. If your income, deductions, and credits will remain similar in 2014, your brackets will also probably remain similar. But if you expect a large increase or decrease in your income for 2014, you might want to recheck your bracket by using the information at your disposal, along with the 2014 tax rate schedules, which you'll find on page 7 of this IRS form (link opens a PDF).
Why you should care
If you're on the cusp of the next tax bracket, you'll want to defer some 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 article on midyear tax-planning tips.
All taxpayers should know how to arrive at their tax bracket and use it to their maximum advantage. You'll need to know it before you make any tax-based decisions.
For more tips on saving taxes, learn about: