Wednesday, September 15, 2010

What's the difference between a tax bracket and a tax rate?

We are all hearing a lot of hype about tax cuts and tax hikes for the middle class, for the rich, for everybody, for nobody.

But, has any pundit or pol explained how taxes work? No. No more than anyone explains what is a small business?

So here's something with which to regale your friends at the next cocktail or tea party -- a little tax savvy.

What’s your tax bracket? It's the same thing as your marginal tax rate. As your taxable income increases so does your federal income tax rate. The rate at which you end up is called your tax bracket. Another term for tax bracket is marginal tax rate.

Tax bracket and marginal tax rate both mean the percentage at which your next dollar of income is taxed. If you’re in a 15% tax bracket, for instance, on the next $100 of taxable income you will pay $15 in income tax. If in a 28% bracket, then $28 of the next $100 taxable income will go to the Feds.

Advancing to a higher tax bracket does not mean that all your taxable income is taxed at the higher rate. It means that any income from that point on is taxed at that rate.

Gross income, age and filing status -- married, single, widow(er), etc. -- determine whether you must file a tax return.

Taxable income is what's left after all deductions have been subtracted. Taxable income determines the rate at which tax is paid

Let's look at Gary Graphic -- single, owns a house, gives a lot to charity.

Gary grossed $250,000 in his design business [Wow! that's a lot.] After deducting business expenses his net income for the design business was $195,000.

Among the deductions from the $195,000 were Gary's self-employed pension contribution, mortgage interest, real estate taxes, and charitable contributions. After all subtractions he had $100,000 taxable income.

Here's how his tax is calculated:
The first $ 8,350 …… is taxed at 10% = $ 835
the next $ 25,600 ….. is taxed at 15% = $ 3,840
the next $ 48,300 ….. is taxed at 25% = $12,075
the last $ 17,750 ...... is taxed at 28% = $ 4,970

Total Income: $100,000 Total Tax: = $21,720

Gary is in a 28% tax bracket. That is his marginal tax rate.

Gary's real tax rate -- we tax pros call it his effective tax rate -- is: just about 22%. Meaning that about 22% of Gary's taxable income went toward federal income taxes.

How did I get that: Divide 21,720 by 100,000

Keep in mind that in this example Gary started with $250,000 income. The tax talk about taxing the rich who make more than $250,000 is not about Gary or most of you unless you are one of the top 3% earners in the country.

If Danworth Design's taxable income were a half million dollars his federal income tax would be $152,684. That is a little more than 30% of his taxable income.

End of today's tax lesson.

June Walker


tylerkb said...

Thanks, June, for the succinct, clear explanation. BTW, I think there's a typo - about 22% comes from dividing 21,720 by 100K, rather than the other way around.

June Walker said...

Thanks, tylerkb. Right you are about the typo. I said it backward. I really appreciate your pointing it out. I fixed.

21750/100000 is 100,000 divided by 21,750 which = 21.75%

And, I'm glad the explanation was clear. That's my goal.