Income tax brackets can be incredibly puzzling. To put it simply, the first dollar you make will be taxed less than the last dollar you make and not every dollar is subject to the same rate.
Your true taxable income is not your annual job salary but the amount you are left with after you’ve made your pre-tax contributions to your 401(k) less your entitled tax breaks. The income classes that define tax brackets are adjusted for inflation each year and vary depending on your filing status -single, married filing jointly or head of household. Currently, the income tax brackets are 35, 33, 28, 25, 15 and 10%. Which bracket you fall into depends on your filing status as well as you income earnings.
The 2012 tax brackets by taxable income levels and filing status below are the rates that apply for taxes you will be filing in 2013.
|Tax Bracket||Single||Married Filing Jointly||Head of Household|
|10% Bracket||$0 – $8,700||$0 – $17,400||$0 – $12,400|
|15% Bracket||$8,701 – $35,350||$17,401 – $70,700||$12,401 – $47,350|
|25% Bracket||$35,351 – $85,650||$70,701 – $142,700||$47,351 – $122,300|
|28% Bracket||$85,651 – $178,650||$142,701 – $217,450||$122,301 – $198,050|
|33% Bracket||$178,651 – $388,350||$217,451 – $388,350||$198,051 – $388,350|
It’s important to know that the income tax bracket determines only the Marginal Tax Rate and differs from the Average and Effective Tax Rate. An individual is able to move to a lower tax bracket, (hence marginal rate) by making an IRA or 401(k) contribution or making charitable donations. In addition, not all of the income is subject to the higher rate. As mentioned earlier, the first dollar you make will be taxed less than the last dollar you make. This means that the first $8,700 you make is subject to the 10% marginal rate, the following $26,649 ($35,350 – 8,701) is subject to 15% which is the next marginal rate up and so on.
The total amount payable after applying various tax rates to portions of your income, divided by your taxable income will determine your Average Tax Rate.
The Effective (or Actual) Tax Rate, on the other hand is the federal income tax liability divided by your annual income. It is less than your Marginal and Average tax rates, considering your taxable income is a lot less than your actual income.
Your actual income is reduced by certain qualifying expenses and contributions such as HSA savings, contributions to IRAs, student loan interest deductions, and self-employment retirement plans. It’s also reduced by exemptions and deductions including state taxes and local taxes. Taking all reductions into consideration, your actual federal income tax rate will result in a smaller Effective Tax Rate.
Income earned from certain long-term investments such as stocks and mutual funds are included in taxable income as well, but are taxed at different rates from the tax brackets. Long-term capital gains in the 10-15% tax brackets are not subject to tax at all, while gains in the 25% tax bracket and above are subject to a 15% tax rate flat. Short-term and ordinary capital gains however, are treated just like ordinary income and taxed at the normal rates.
As you can see, income tax brackets have little bearing on what you will ultimately need to pay in the end. Both the amount and type of income will impact your Effective (Actual) Tax Rate and with further exemptions and deductions, the rich can indeed strategically reduce their taxable income to fall in the lower bracket, getting away with less payable tax. The common saying “The rich will only get richer” does bear a lot of truth after all.