Are You Being Misled By Your Tax Bracket?

Before you go, we thought you'd like these...

Tax BracketA lot of tax talk focuses on tax brackets. But in order to get the full picture of what you hand over to Uncle Sam, you need to consider not your bracket, but your effective tax rate.

Consider the table below of the brackets that apply to the tax returns we're preparing now for 2011.

A single taxpayer earning $50,000 might assume that their tax rate is 25%. That's not quite right, though. That 25% rate is the marginal rate, the rate at which your next dollar of earned income will be taxed. But it's not the rate at which all of your $50,000 is taxed.


Tax rate

Single filers

Married filing jointly or qualifying widow/widower

Married filing separately

Head of household

10%

Up to $8,500

Up to $17,000

Up to $8,500

Up to $12,150

15%

$8,501 - $34,500

$17,001 - $69,000

$8,501- $34,500

$12,151 - $46,250

25%

$34,501 - $83,600

$69,001 - $139,350

$34,501 - $69,675

$46,251 - $119,400

28%

$83,601 - $174,400

$139,351 - $212,300

$69,676 - $106,150

$119,401 - $193,350

33%

$174,401 - $379,150

$212,301 - $379,150

$106,151 - $189,575

$193,351 - $379,150

35%

$379,151 or more

$379,151 or more

$189,576 or more

$379,151 or more


The Right Way to Look at the Tax Table


For those in the 25% bracket, the 10% and 15% rates also apply. Look closely at the table above, and you'll see that your first $8,500 in income is taxed at just 10%. Then, the next $26,000 that you earn (from $8,501 to $34,500) is taxed at 15%. It's only the amount over $34,500 that's taxed at 25%.

Even that isn't the full picture, though. (No one ever claimed that deciphering the tax code was simple.) That's because the income you're taxed on isn't all the money you collected over the course of the year.

Not all of your $50,000 salary is taxed


Let's continue to use our $50,000 single filer as an example. That income is their gross income, which gets adjusted by various tax rules.

For example, if you made qualifying contributions to IRAs or other retirement accounts, those sums are subtracted. So are alimony payments and some other expenses. These subtractions leave you with your adjusted gross income, or AGI.

Sponsored Links

Your AGI then goes through its own set of adjustments, as exemptions and deductions are subtracted. Many taxpayers apply the standard deduction to their AGI, while others itemize their deductions. You're allowed to use whichever deduction is greater. You can also apply exemptions to your AGI -- one for yourself and one each for a spouse and/or dependents.

After all this, you're left with your official taxable income -- and it's this amount that counts when you apply the tax brackets.

So our hypothetical filer clearly isn't getting whacked with a 25% haircut on all the money he collected over the year. If your gross income is $50,000 and your taxable income is $40,000, this handy tax-rate calculator shows that your effective tax rate is just 12.25% -- even though you're in the 25% tax bracket.

It's all a reflection of the fact that our income tax system is a progressive one, with higher levels of income taxed at higher rates.

Other Income, Other Taxes

Overall, though, our tax system isn't always as progressive as we may think it is. That's because there are other taxes and other rates that factor into the big picture.

If you collect dividend income or have reaped some capital gains on investments, for example, those are currently taxed at a low 15% rate for most people. Within the past few decades, dividends have been taxed at a rate as high as 91%, and capital gains at 40% -- the current rates are extremely low, historically speaking. These low rates are why wealthy folks such as Warren Buffett and Mitt Romney have such low effective tax rates: Much of their income comes from dividends and capital gains.

The bottom is that while there's certainly a lot of room for improvement in our tax system, it has managed to keep our country running for several centuries now. As former Supreme Court Justice Oliver Wendell Holmes, Jr., once noted, "Taxes are the price we pay for civilization."

Longtime Motley Fool contributor Selena Maranjian holds no position in any company mentioned. Click here to see her holdings and a short bio.

Read Full Story

People are Reading