You can’t go through tax season or file your taxes without knowing how tax brackets work. The U.S. has a progressive tax system that does one thing well, it tells you the tax bracket you fall into, but it doesn’t tell you the whole story.
While someone may sit in the 25% federal tax bracket, that doesn’t mean they actually pay that much in taxes. In fact, they pay less than 25% in taxes because of how the tax system works. Let me explain.
Marginal Vs. Effective
The tax bracket you fall into is your marginal tax rate. The marginal tax rate represents the tax you pay on the last dollar you earn. But it’s not the tax rate you pay on every dollar you earn.
To find the tax rate you pay on your total taxable income, you need to find the average tax rate, called your effective tax rate. To do that, you need a bit of math.
How It Works
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 this example, assume this single person, let’s call her Sue, has a taxable income of $500,000. Sue’s income is far above average (because I wouldn’t be able to use the entire table below that I labored over for hours). Continue Reading…