I had a two conversations this weekend about tax brackets. Both conversations started with the same statement: “Which tax bracket am I in?” Because many of you may have asked the same question at some point, I hope this post will provide some clarification.
The schedule of tax rates is progressive (or sometimes referred to as gradual). This means that as a taxpayer’s income increases, so does his or her tax liability, however, at a greater rate. The rate of tax at each bracket level is referred to as the marginal rate of tax, while the rate applicable to a taxpayer’s entire income is called the effective rate. The effective tax rate is derived at by dividing total tax liability by total taxable income. It is this distinction that often has taxpayers confused. Because the tax rates are progressive, the lower segments of your income will be taxed at the lower marginal rates (i.e. 10%, 15%, etc). Therefore, by determining what tax bracket you are in may not effectively answer any questions you may have regarding your tax liability. Here is a simple example demonstrating the distinction between effective and marginal tax rates.
Example: Suppose I am a single individual with a $150,000 of taxable income (I could only hope). My taxable income is subject to a 2009 rate of —
10% on the first $8,350 = $835
15% on the next $25,600 ($33,950-$8,350) = $3,840
25% on the next $48,300 ($82,250-$33,950) = $12,075
28% on the next $67,750 ($150,000-$82,250) = $18,970
Total Tax Liability = $35,720
Effective Tax Rate = $35,720/$150,000 = 23.8%; Top Marginal Tax Rate = 28%
Here, my income is not taxed at a flat rate and thus it is not accurate to place myself in one particular bracket. Rather, the lower segments of my income in the example were taxed at lower rates, while the higher segments of my income were taxed at higher rates. Therefore, my effective tax rate is 23.8% and the top marginal rate for which I am taxed at is 28%. Depending on what information you are seeking will determine when you would want to know what your top marginal tax rate is as opposed to your effective tax rate.