Your Actual Tax Rate Is Not Your Tax Bracket

When people talk about their tax bracket, they are usually talking about their marginal tax rate - that is, the amount of tax on the next dollar they make. Often times people get this confused with their actual tax rate, which is much much lower after you take into account your deductions, such as a 401k contribution, medical benefits, mortgage interest, etc.

For example, here are my marginal versus my actual tax rates for the last three years:

Just some explanation before we continue, in 2003 I started my job part way into the year and so my salary was much less than in 2004 and 2005 and I was aggressive in my contributions to my 401k, which explains the percentage disparity between 2003 and 2004/5 in terms of taxes paid. The percentage fell from 2004 to 2005 because I purchased a home and now had more in terms of deductions, mortgage interest and the like, than before.

As you can see, in all three years my marginal tax rate was far higher than my actual tax rate because of the various deductions you’re allowed to take. Even if you weren’t allowed to take any deductions (not even the standard deduction), someone who makes $50k/yr is in the 25% tax bracket but only pays 18.12% in taxes ($9,057.50). If all they do is take the standard deduction of $5,150, then their tax burden falls to a lucky $7,770, or a mere 15.54%.

Why is this so? It’s because your marginal tax rate isn’t really your tax rate, people just misunderstand what it means. Since your first dollar is truly taxed at 10% (well, it’s really your first dollar after your first 5150 or more depending on what other breaks you’re eligible for) and not at your published tax rate, the marginal tax rate isn’t only important when you’re thinking at the fringes.

Where would knowing your marginal tax rate be important? Let’s say you’re thinking about contributing more to your 401K, if you were Mr. $50k, each dollar you contributed would only decrease your take home pay by about 75 cents. If you feel you can reduce your need for that money this month, you can actually contribute more on a pre-tax basis, about 25% more. So in those types of calculations, marginal tax rate is important, otherwise don’t stress it but do understand how it works.