Your tax bracket might seem steep, but it doesn't reflect your overall tax rate. Photo: Juan Rubiano via Wikimedia Commons.
When you're talking about taxes, you'll probably hear people talk about their "tax bracket" but not about their "effective tax rate." That's a shame, because taxpayers are often misguided when they ask, "What is my tax bracket"
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If you want to know how much money the government is actually taking out of your paychecks, then you need to learn your effective tax rate.
Tax-rate basicsThe income tax rates that you'll see broken out in tax publications are "marginal" rates. They're listed in schedules that our friends at the IRS publish each year. For example, check out the 2015 tax brackets:
The tax rate gets higher as incomes rise, because we have a "progressive" tax system, levying higher tax rates on those who earn more. Some will argue that it's unfair, often preferring a "regressive" system that taxes everyone at about the same rate. We don't have a flat tax rate, but note that everyone pays the same tax rate on income that falls withing certain ranges. For example, everyone pays 10% on their first $9,925 in income.
The number in the tax bracket isn't as important as you think.
Your effective tax rateMany people assume, incorrectly, that if their tax bracket is 25%, then all their income will be taxed at 25%. That's not the case at all.
Think about it this way: If you're a single filer with $50,000 in taxable income, then you are in the 25% tax bracket. But you're also in the 10% and 15% brackets. The tax brackets above show that the first $9,225 of your income is taxed at just 10%, and the next $28,225 is taxed at 15%. It's only the income above $37,451 that's taxed at 25%. The 25% is your marginal tax rate -- the rate at which your last dollar in income is taxed.
The reality is that you're actually paying several different tax rates on different sums; more than one tax bracket applies to your income. So what's your overall tax rate? Well, your total tax bill, calculated from the brackets above, is $8,293.75. If you divide that by your taxable income of $50,000, you'll get 0.17, or 17%. That's your effective tax rate -- and it's the rate that should matter most to you, because it reflects the rate you actually paid. Your marginal rate just reflects the highest rate at which you're taxed.
This information can come in handy when you run across someone referring with a heavy sigh to their 39.6% tax bracket. Remember that only their income above $413,200 is being taxed at that rate.
At TaxAct.com, you can enter various taxable incomes and see which 2014 tax brackets apply and what their overall effective tax rate is. (The site should be updated with 2015 numbers within a few months.) For example, someone earning $200,000 will be in the 33% bracket, but their effective tax rate will be 24.9%, while a person with a taxable income of $50,000 will be in the 25% bracket but have an effective tax rate of 16.7%. Those are big differences.
So the next time you find yourself asking "What is my tax bracket?" snap out of it and ask yourself instead, "What is my effective tax rate?"
The article "What Is My Tax Bracket?" Is the Wrong Question to Ask originally appeared on Fool.com.
Longtime Fool specialistSelena Maranjian, whom you can follow on Twitter,has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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