Taxes are always confusing, and marginal tax rates are no exception. Although I am no accountant, here are some clarifications on how to use the 2006 tax bracket table I just posted.
First, it should be noted that it is for taxable income, not gross income. In very broad terms, taxable income is your gross income minus exemptions and deductions. Everybody has the standard deduction ($5,150 for single taxpayers and $10,300 for married taxpayers filing jointly for 2006), and many people have more from things like personal and dependent (kids) exemptions, mortgage interest, and state income taxes. For example, if you were single and had $35,150 in gross income, with the standard deduction you would only have a taxable income of $30,000. You owe no tax on the first $5,150.
But remember, gross income also takes into account interest and capital gains from selling investments in addition to just salary. So estimating your actual taxable income without actually filling out a 1040 form can be a bit tricky.
Second, it’s your marginal tax rate, not your overall tax rate. Marginal tax rate means this is the rate at which your next dollar earned will be taxed. So it’s not retroactive to the dollars you already earned, and you can never make less money after getting a raise.
For example, if you were single and had $30,000 of taxable income, and got a $1,000 raise later to $31,000, your entire $31,000 will not be taxed at the 25% rate (a big jump from 15%!). Only the $350 above $30,650 would be taxed at the 25% rate. Your total taxes would then be:
10% x $7,550= $755 +
15% x ($30,650-$7,550) = $3,465
25% x ($31,000-$30,650) = $87.50
——————————————-
Total $4,307.50
So, if we again take the super-simple case of you being single and taking the standard deduction only, your post-raise gross income would have been $31,000 + $5,150 = $36,150. Paying $4,307.50 of tax on $31,650 of gross income is actually an overall tax rate of only 11.9%.
This is also why when you get a year-end bonus, it seems like the tax bite is enormous. There is no special “tax rate for bonuses” at the federal level, what is happening is that your bonus is being withheld at at higher rate to ensure that you pay enough taxes.
Finally, all this ignores additional hit from state income taxes and payroll taxes like Social Security and Medicare.
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Don’t forget about personal exemptions… In your super simple case, your effective tax rate would have been even lower.
I’m not a payroll accountant, but I think I remember seeing supplemental income withholding tables or a formula somewhere, or that the employer has the option of withholding a flat 25% from a bonus or supplemental income.
I have a graphic somewhere that shows how our tax system usually seems to be pretty progressive… That the lowest 50% of all taxpayers pay a marginal amount of tax, or something to that effect. It’s actually pretty interesting for all those nay-sayers.
Yes I remember as a student paying very little in taxes, especially after the education credits as well.
Nice job on talking about marginal tax rate. I’ll give an extra SavingEverything pointer: when you buy a house, dont get lured into thinking that all of your interest and property taxes will be taxed at your tax bracket. Technically, you wont get your standard deduction anymore; instead, you will be itemizing your taxes and property interest (estimated ~80% for first 4-5years), which can lower your overall income to the lower bracket.
As Hal mentioned above, the personal exemptions ($3,300 in 2006 for each exemption) are also subtracted from gross income before figuring taxable income. So that taxpayer filing as SINGLE with the taxable wages of $36,150 will reduce that amount by 5,150 & 3,300 for a total $8,450 in deductions to arrive at taxable income (not including any credits or other taxes.
The example above also assumes that the taxpayer is not yet 65 (or blind) by the end of the tax year, in which case the standar deduction would be higher for the single filer.
It’s also important to note that there are different categories that make up “gross income” and some are taxed at different rates. For instance, capital gains and dividend income will probably be taxed at a different rate than the marginal tax rates you listed.
Suffice it to say (as a California tax preparer) i must suggest you exercise substantial caution when giving tax information. Nonetheless, thanks for all the information you give in your blogs!
I usually hate to write about taxes for this exact reason. There are just too many exceptions to any rule by age, income, geography, and the color of your eyes.
Could you also clarify AGI, which determines if you’re eligible for RothIRA or not?
Thanks,
David
You may not make less after getting a raise, but you sure as hell could be making less than you thought you would. At the 35% tax bracket you start getting only 65 cents for every dollar of work you do. The government just takes too damn much.
You’re right – tax law is extremely complicated. There are a million exceptions to every case, and it becomes increasingly complex with the widening impact of the AMT. One nice thing about AMT, though, is that the tax brackets aren’t nearly as tough to figure out – there’s only two rates, 26% and 28%, and the 28% doesn’t kick in until $175,001 of taxable income for MFJ taxpayers. Just a pointer – if anyone is still doing taxes by hand, I strongly urge you to consider, at the least, using tax software instead, especially in light of things like the AMT which is essentially a “shadow” tax. If your tax situation is more than just blindingly simple, hire an accountant, it’s money well spent. I guess in the interest of full disclosure I should mention that I am a tax accountant. Is my opinion biased?
You paid a little homage to payroll deductions (SS & Medicare) at the end of your post, something I wrote about a little way back. I called them take home pay brackets and you might be interested in seeing them.
I think you’re example was a fine one and illustrates that just because your marginal rate is higher, your effective rate may not be. It’s because of all these complexities that this is possible. I also think you caveated your entry enough to say that you aren’t in the business of giving advice and you were just trying to make it simple for people. Good job with that.
what is the best website (free) for filing your tax?
I’ve always wondered about taxes for bonuses – when I got my first-ever bonus this summer, it was taxed at an astonishing 45% (including federal, state, everything, etc.)! I was crestfallen. 🙁
Great post. This is the kind of thing that should be required knowledge for graduating high school. Unfortunately I think the teacher’s union has it in their best interest for people to be clueless about how taxes work. My girlfriend insisted that she “did not see any extra money” from the Bush tax cuts. So I just ran her 2004 W-2 through TaxCut 2000, turns out the tax cuts netted her $1200. I told her that the IRS does allow you to pay extra if you would like. Needless to say she chose to keep the $1200.
Just some added fuel to the Roth IRA fire…..Current tax law will allow persons to convert their IRA/401(k)s to ROTH IRAs or 401(k)s in 2009. Why should you consider? The conversion will result in tax on that amount you contributed orig as it was not taxed at that time. Normally you have to pay the tax in the year of conversion. Under the new law you can pay it over 2 years. The money now in the Roth retirement plan grows tax deferred, but is not taxable when you receive distributions. (because you paid tax when you converted) There is a growing concern that social security will be defunct very quickly due to the baby boomers retiring. The only fix will be to raise taxes or reduce benefits (or both). It used to be the theory that you will be in a lower tax bracket when you receive money from your IRA, but now some think that might not be the case. Hence, the Roth IRA could be a valid option. Of course it depends on future investment returns, balance in the retirement accounts, other pensions or sources of income expected, etc. etc. But, one more thing to contemplate 😉
Bonuses are taxed at a statutory 28% fed rate, ss and mc at 7.65% and then state and/or city taxes at the applicable rate.
You mean taxes are withheld at that rate, yes? Bonuses are still just part of gross income.
Correct, the %’s cited are withholdings (some take longer than others to be potentially refunded aka social security and medicare :grin:)
Great information here. Hopefully someone can help me solve two delimia’s. I’m 55 and retired (not by choice). I can pay the taxes to convert my SEPP/IRA funds to Roth. But should I at this age? Then, the 0% long term capital gains tax starting in 2008 for the two lowest tax brackets, I’m in that range. How much can we cash in tax free and reinvest per year without it raising our marginal tax rates. In other words I’m real ignorant about the whole confusing mess.