Tax Brackets, Explained

Alden Wicker
Posted

There are two things you should know about tax brackets: The first is that they are misleading.

In a perfect world, we would just look at your tax bracket (10%, 25%, etc), multiply that by your income, and voilà! You get the amount you’ll pay this year in taxes.

But it’s not that simple. (Nothing in taxes ever is, right?) Tax brackets give you only a very general idea of how much in taxes you’ll pay.

For that reason (and this is the second thing you should know about tax brackets), you yourself won’t find your tax bracket very useful if you’re doing your taxes on your own. An accountant will find it useful, but we can save you a heart attack right now by telling you that if you’re in the 25% tax bracket, you don’t actually pay 25% of your income in taxes. You pay less. Much less.

If you want to understand why this is so, read on.

Your Marginal Tax Bracket vs. Your Effective Tax Rate

The most important thing to know is the difference between your marginal tax bracket and your effective tax rate. Think of your marginal tax bracket as just one part of the equation that determines how much you pay in taxes. Think of your effective tax rate as how much you will actually pay compared to your taxable income. So if your marginal tax bracket is 15%, you could pay an effective tax rate as low as 5%. That is much more palatable, right?

How It Works

Why is your effective tax rate lower? Well, first of all, you aren’t taxed on your entire income. You’re taxed on your taxable income. You can look at your tax return from last year and find the item that says “Taxable Income.” It’s not very prominent, but it’s there (line 6 on the 1040-EZ form, line 27 on 1040A form and line 43 on the 1040 form).

Once you know your taxable income and your filing status (find that out by using our easy flowchart) you can figure out what tax bracket you fall into. Use this chart:

Tax rate Single filers Married filing jointly or qualifying widow/widower Married filing separately Head of household
10% Up to $8,700 Up to $17,400 Up to $8,700 Up to $12,400
15% $8,701 – $35,350 $17,401 – $70,700 $8,701- $35,350 $12,401 - $47,350
25% $35,351 - $85,650 $70,701 – $142,700 $35,351 - $71,350 $47,351 - $122,300
28% $85,651 - $178,650 $142,701 – $217,450 $71,351 - $108,725 $122,301 - $198,050
33% $178,651 - $388,350 $217,451 - $388,350 $108,726 - $194,175 $198,051 - $388,350
35% $388,351 or more $388,351 or more $194,176 or more $388,351 or more

The second reason why you pay less than your tax bracket says you will is that your income isn’t all taxed at the same rate. It’s taxed in chunks. It’s called a progressive tax, because the more money you make, the more you are taxed.

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For Example …

Let’s illustrate with a very simplified example: Let’s say you are a single taxpayer with a taxable income of $80,000. As you can see from the chart, you are in the 25% tax bracket. Does that mean you’re paying a quarter of your taxable income, or $20,000, to the government? No. (Phew!)

Instead, each chunk of your income that falls into a bracket is taxed at a different rate. $8,700 of your income will be taxed at a 10% rate. The next portion of the income you made between $8,700 and $35,350 (or $26,650 in total) will be taxed at a 15% rate. And the remaining portion that you made above $35,351 will be taxed at a 25% rate. That means that after deductions and exemptions, even though you are in the 25% tax bracket, you are only paying 22% of your taxable income. We like that much better.

Who’s Afraid of a Tax Bracket?

What this also means is that if you got a raise which bumped your taxable income up to $90,000, your taxes won’t suddenly skyrocket. Only the income you made above $85,651 will be taxed at 28%. Which, frankly, isn’t much of a difference. (In this example, being in the higher tax bracket would only cost you $1,218 more on that $10,000 boost, in case you’re wondering.) You can also get bumped into a higher tax bracket by losing a deduction, because it increases your taxable income. Yes, being in a higher tax bracket will mean you will pay more in taxes, but don’t turn down a raise because you’re afraid of a new tax bracket!

So now, hopefully you can see why your tax bracket is useful for accountants, but not that useful for you.

Once you know how much you paid in taxes for 2012, you can divide that by your taxable income to find out your effective tax rate for 2012. But you don’t have to do that in order to do your taxes—it’s just for curiosity’s sake.

  • Lee

    I considered myself pretty money savvy, but learned something new in this article. Really clear explanation of how tax brackets work.

  • Joe

    Very good….thank you.