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How Do Tax Brackets Work?

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Form 1040When I was younger and I just started working, I didn’t know how tax brackets worked because I would do my return in TurboTax and pay whatever I owed. I didn’t care much about tax brackets because, honestly, it didn’t really matter to me. So one day I look at the Federal tax brackets and was perplexed as to how they were set up (this was back in 2003 but in order not to confuse you, I’ll use 2013 tax bracket numbers in my story). I was making a great salary for a 23 year old, around $60,000, a year and I saw that I was firmly in the 25% tax bracket. When I went to do my taxes, I saw that my effective tax rate, as reported by Turbotax, was actually under 4%!

Why were my taxes so low? First, I started working in June so my wages were less than $40,000 (I had a small signing bonus and I also worked my last semester of college), and after the standard deduction and 401(k) contributions, my taxable income was around $25,000. That next year, I was given a raise of 4% and I saw that I’d still be in the 25% bracket but my effective tax rate was under 14%.

How could my tax rate be so much lower than my tax bracket?

Marginal Tax Rates

The reason is because the brackets don’t illustrate your tax rate on all of your income, just the income that falls within the bracket itself. That’s what marginal means, the tax rate is assessed on your next dollar, not every dollar. Here are the 2013 tax brackets:

Tax Bracket Single Married Filing Jointly Head of Household
10% Bracket $0 – $8,950 $0 – $17,900 $0 – $12,900
15% Bracket $8,950 – $36,250 $17,900 – $72,500 $12,750 – $48,600
25% Bracket $36,250 – $87,850 $72,500 – $146,400 $48,600 – $125,450
28% Bracket $87,850 – $183,250 $146,400 – $223,050 $125,450 – $203,150
33% Bracket $183,250 – $400,000 $223,050 – $450,000 $203,150 – $400,000
39.6% Bracket $400,000+ $450,000+ $400,000+

As a single filer, the first $8,950 of taxable income (this is after all of your deductions and exemptions) is taxed at the 10% rate. The 8,951st dollar is taxed at 15%. The 8952nd dollar is also taxed at 15%. This is why, despite being in the 25% tax bracket (even with deductions and exemptions), my tax rate was still under 15% – I was deferring a lot of income via a 401(k) and because of marginal tax rates.

This misunderstanding is very common. Every year, around tax time, I get a deluge of emails about this subject because, let’s be honest, it’s not very clear. Most of the time it doesn’t matter but occasionally I get emails from readers who are considering a career change but are worried they’ll take home less money because the increase puts them in a higher tax bracket.

(Photo: John-Morgan)

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11 Responses to “How Do Tax Brackets Work?”

  1. Great explanation of tax brackets. I used to think the same thing until I understood what marginal actually meant.

  2. Thanks Jim for this clear explanation of a commonly misunderstood concept. Depending on the question or issue, we need to know which tax rate–marginal or effective–is pertinent.

  3. Julie @ The Family CEO says:

    It took me a long time to figure that out too. Great explanation. Luckily our CPA figures our effective tax rate s part of our return. Makes me feel a little better, but not much. ;)

  4. Texas Wahoo says:

    Also note that because of deduction/credit phase-outs at certain income levels, it is possible to have a higher overall tax rate relative to your income, but that is not necessarily tied to the tax bracket.

  5. NateUVM says:

    Yeah, it’s tied to having made more money and being ineligible for deductions/credits that were not intended for higher income levels. Not really what’s being discussed here.

  6. We’re in the 25% bracket, and our effective federal tax rate was 9% last year. We have kids, a mortgage, lots of retirement, and lots of charitable donations, so it adds up.

  7. admiral58 says:

    People just have to do their own research and figure things out, including taxes.

  8. I’ve often heard people say they have to watch how much they make this year because their income is close to the next tax bracket and they don’t want their taxes to go up. I think it’d be nice if when people did their taxes online they were able to see the percentage of their income that really went to taxes. I think many people believe they are paying a lot higher percentage than they really are.

  9. “Marginal” is a very tough concept indeed. My wife and I began an LLC last year, and our taxes this year were even more complicated. I have now gone through an entire tax year cycle of paying estimated taxes, and am just now beginning to understand how the tax rates really work.

  10. Shirley says:

    Thanks, Jim, for another complicated subject made so much easier to understand. A link to this one will definitely be passed on to several young people.

  11. ace carolla says:

    that’s why people should always do their best to max out their 401k/403b/457.

    it’s a double whammy for the penny wise person!

    on a side note on investing, clark howard says that the first 5000/5500 should be put into an ira/roth ira. gotta love the big fella!

    so, do the ira/roth ira first, then contribute the max to your 401k/etc.

    boo ya!


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