Tax Brackets Explained

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Being in a high tax bracket seems to be something that people envy (in others) but avoid (for themselves). But what does that mean, and what does it matter? (See also: 15 Surprising Facts About Income Tax)

Here’s what to know about tax brackets:

• Your tax bracket is based on taxable income (not your annual salary) and filing status with the IRS (such as Single or Married Filing Jointly)
   
• The percentage associated with your tax bracket is your marginal tax rate
   
• The percentage associated with your tax bracket is not the same as your average or effective tax rate
   
• You may be able to move to a lower tax bracket by making contributions to a tax-deferred investment account such as an IRA and 401(k); making charity contributions; or selling stock held in regular accounts at a loss
   
• Selling stock at a gain may move you to a higher tax bracket, even if your earned income stays the same

IRS Tax Brackets

Generally, when people talk about tax brackets, they are referencing income levels associated with IRS (federal) tax rates for ordinary income tax and not other types of taxes or withholdings for state and local taxes. Federal income rates and tax brackets change periodically. To give you an idea of current tax brackets, consider these income levels and percentages using information from IRS Publication 505, Tax Withholding and Estimated Tax.

2012 Tax Brackets by Taxable Income

Single Filing Status

• 10% – less than $8,700
• 15% – between $8,700 and $35,350
• 25% – between $35,350 and $86,650
• 28% – between $86,650 and $178,650
• 33% – between $178,650 and $388,350
• 35% – over $388,350

Married Filing Jointly

• 10% – less than $17,400
• 15% – between $17,400 and $70,700
• 25% – between $70,700 and $142,700
• 28% – between $142,700 and $217,450
• 33% – between $217,450 and $388,350
• 35% – over $388,350

What Difference Your Tax Bracket Makes

Your tax bracket determines your marginal tax rate. This percentage can be important when considering financial decisions. Specifically, knowing the marginal tax rate helps you to determine the impact of certain actions (such as making a charitable contribution or making an IRA contribution) on your cash flow.

In trying to understand precisely what “marginal” in marginal tax rate means, I came upon several definitions. The one that made the most sense to me described “marginal” as being the one on the top margin of your income. (Definition from the Dictionary of Financial Terms from Lightbulb Press)

For example, if you itemize deductions and you are in the 25% tax bracket, then a charitable donation of $1,000 will “cost” you $750; that is, you give away $1,000 but get a tax break of $250. Similarly, if you are in the 35% tax bracket, then you could reduce your tax bill by $350 for the same contribution.

Likewise, putting money away in an IRA or 401(k) can have tax benefits. These benefits can be measured by your marginal tax rate. A $2,000 contribution might help you to reduce your tax liability by $200 if you are in the 10% tax bracket or $500 in the 25% tax bracket. When you reduce your taxable income, you may move to a lower tax bracket if you happen to be on the edge of a bracket.

Marginal Tax Rate vs. Average Tax Rate

You pay taxes based on a combination of tax rates (unless you are in the lowest tax bracket, and then you pay based on the lowest rate only). That is, taxpayers don’t pay federal income tax that is equal to their taxable income multiplied by their marginal tax rate. Just a portion of your income is taxed at this higher rate.

To determine your average tax rate, you need to calculate how much your taxable income is taxed at each level.

For example, if you are single and your taxable income is $50,000, then your tax calculation (using Publication 505 to estimate your tax liability) is $4,867.50 + 25% x ($50,000-$35,350) = $8,530.00. Or, you can calculate this dollar amount by applying various tax rates to portions of your income, like this:

• Portion 1: $8,700 x 10% = $870
• Portion 2: ($35,350-$8,700) x 15% = $3,997.50
• Portion 3: ($50,000-$35,350) x 25% = $3,662.50
• Total of All Portions = $8,530.00

Then take the total tax amount and divide by taxable income to calculate the average rate. In this case, the average tax rate is 17.06% ($8,530 / $50,000).

Average Tax Rate vs. Effective (or Actual) Tax Rate

Now that you see how the marginal rate differs from the average rate, consider how the average rate varies from your effective or actual rate. The actual rate (federal income tax liability divided by annual income) is less than marginal and average tax rates when you consider that your taxable income is much less than your actual income.

Here are some of the factors in determining taxable income.

Income

For many people, annual income is simply your annual salary or total of yearly wages. But income can also include earnings from a side business or freelance gigs, unearned income from interest and dividends, capital gains from the sale of stock, sweepstakes' winnings, unemployment compensation, and payments from pensions. (For a complete list, review IRS Form 1040 (PDF) and instructions (PDF), call the IRS, or talk to your tax professional.)

Qualifying Expenses and Contributions

Certain expenses and contributions are deducted from income. These may include Health Savings Account (HSA) deposits, student loan interest deductions, contributions to IRAs, and self-employment retirement plans. Certain credits are also available, further reducing tax liability.

Exemptions and Deductions

Your income is reduced by exemptions (personal and dependent) and the standard deduction (PDF) or itemized deductions.

So, your taxable income may be $50,000, but your actual income could be $50,000 + $3,700 (personal exemption for 2011) + $5,800 (standard deduction for 2011) or $59,500 (more if you made contributions to your IRA, 401(k), or HSA). In this case, your actual federal income tax rate is 14.34%. You will probably pay other taxes, like state and local taxes, so if you want to get a complete picture of your tax rate, then add up all taxes and divide by your income. 

Capital Gains and Tax Brackets

Long-term capital gains from the sale of investments like stocks and mutual funds not held in tax-advantaged accounts are taxed at special rates. Through 2012, these long-term gains have a tax rate of 0% for those in 10% and 15% tax brackets and 15% for those in tax brackets of 25% and above. Qualified dividends are also taxed at these favorable rates.

Income from long-term capital gains is included in taxable income, so you can’t sell lots of stocks for a profit and expect to pay nothing in taxes. However, if you have relatively low income and sell some mutual funds at a gain, then you may be able to benefit from this tax arrangement.

Short-term capital gains (held for one year or less) and ordinary dividends are treated as ordinary income and taxed at regular rates.

When retirees take money out of their Roth accounts, they pay no taxes on qualified distributions (under current tax laws). Compare that to ordinary tax rates for distributions from traditional IRAs and 401(k) accounts.

So both the amount and the type of income that you have can impact your actual tax rate. That’s why some people can have high incomes but lower than usual tax rates.

Have you ever made a financial decision based on your tax bracket? Share in the comments.