We can’t go through tax season without covering how federal income tax brackets work. The U.S. has a progressive tax system. While someone may be sitting in the 25% federal tax bracket, that doesn’t mean they actually pay that much in taxes. It only means that 25% is the marginal tax rate.
The marginal tax rate represents the tax rate on the last dollar of your income earned. It doesn’t represent the tax rate on your total taxable income.
To find the tax rate we pay on our total taxable income we need to find the average tax rate. Which takes a bit of math.
The best way to explain it is with an example. I’ll be using the 2012 federal tax brackets for a single person as a reference. For our example we’ll assume this single person has a taxable income of $500,000. Which is beyond average but I wouldn’t be able to use the entire table below that I labored over for hours.
|Tax Rate||Single||Income Break Down||Taxes on $500,000 in Taxable Income|
|10%||$0 – $8,700||The first $8,700||10% of $8,700 or $870|
|15%||$8,700 – $35,350||The next $26,650||$870 plus 15% of $26,650 or $4,867.50|
|25%||$35,350 – $85,650||The next $50,300||$4,867.50 plus 25% of $50,300 or $17,442.50|
|28%||$85,650 – $178,650||The next $93,000||$17,442.50 plus 28% of $93,000 or $43,482.50|
|33%||$178,650 – $388,350||The next $209,700||$43,482.50 plus 33% of $209,700 or $112,683.50|
|35%||Over $388,350||Amount over $388,350||$112,683.50 plus 35% of $111,650 totaling $151,761.00 in income tax!|
As we see from the table, we are only taxed on the amount of income that falls into each tax bracket. For that single person making $500,000, the first $8,700 will be taxed at the 10% tax rate, then the next $26,650 ($35,350 – $8,700) will be taxed at the 15% tax rate. The next $50,300 will be taxed at 25% and so on as the last column shows. That shows us a total of $151,761 in income taxes. We can divide that total by the taxable income ($151,761 / $500,000) to get an average tax rate of just over 30%.
For another example lets use a more realistic $35,350 in taxable income. This person will pay 10% taxes on the first $8,700, then pay 15% on the remaining $26,650. Which comes to $4,867.50 in taxes or an average tax rate just under 14%. If that same person made just $1 more, moving them into the 25% tax bracket, only the $1 would be taxed at 25%. Which amounts to 25 cents in more taxes.
So what does all this mean. We should still try to lower our taxes as much as legally possible by maximizing credits, deductions, and contributions to retirement accounts. So when you file your taxes, don’t be afraid of earning more money and falling into a higher marginal tax rate.
We will always pay more taxes as our income increases. But, when our income increases, our after tax income will always increase too.