It's common for us taxpayers to think about, and occasionally look up, our tax bracket, to see how big a tax hit we're taking. But many people misunderstand the tax bracket concept.
You might, for example, glance at the table below, which features the tax brackets for the current tax year, and note that your taxable income of $50,000 parks you in the 25% bracket. You might then assume that your tax rate for those 50,000 dollars (as a single person) is 25%. Wrong!
Married filing jointly
Head of household
Up to $8,925
Up to $17,850
Up to $8,925
Up to $12,750
$400,001 or more
$450,001 or more
$225,001 or more
$425,001 or more
Here's what really happens: Your first $8,925 of taxable earnings are taxed at 10%. Then, your next $27,325 is taxed at 15%. Finally, the remainder of your taxable income, $13,750, is taxed at 25%. So actually, most of your dollars got hit with a 15% tax rate. Still, the answer to the question, "What tax bracket am I in?" isn't 15%.
Instead, when someone refers to your "tax bracket," it usually means the highest rate at which you're being taxed - and the rate at which your next dollar of taxable income will be taxed. That's also referred to as your "marginal" tax rate. Most of us have more than a single rate that affects us, though. For example, someone with taxable income of, say, $500,000, will actually pay taxes at every bracket's rate. In our example, your tax bracket, and your marginal tax rate, would be 25%.
The marginal tax rate matters for planning purposes. If you're wondering whether to generate more income in the year, for example, you'll know that it will be taxed at your marginal rate. Just remember to keep things in perspective: If additional income kicks you into a higher bracket, it doesn't mean that all your income will suddenly get taxed at that rate. Not at all.
The tax rate that should usually interest you most is your "effective" tax rate. That's the tax rate you actually pay on your taxable income. In the example above, you'd pay $892.50 (that's 10% of $8,925), plus $4,098.75 (that's 15% of your next $27,325), and $3,437.50 (that's 25% of your final 13,750). Add them up, and your total tax paid would be $8,428.75. Divide that by the $50,000 you started with, and you'll see that your effective tax rate is 0.17, or 17%. That's much more attractive than 25%, right?
So, next time you ask yourself, "What tax bracket am I in?" be sure to look at the big picture, not just your marginal tax rate.
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The article "What Tax Bracket Am I In?" -- "It's Complicated." originally appeared on Fool.com.
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