The Progressive Nature of the Federal Income Tax
Taxes can be classified as progressive or regressive. The federal personal income tax is a progressive tax because the tax rate increases as a taxpayer’s taxable income increases. A higher income implies a greater ability to pay. As Table 4.1 shows, the higher portions of a taxpayer’s taxable income are taxed at increasingly higher rates under the federal income tax.* A regressive tax operates in the opposite way. That is, as income rises, the tax demands a decreasing proportion of a person’s income. An example is a state sales tax, since a rate of perhaps 5 percent might have to be paid by everyone regardless of income
The Marginal Tax Rate Is Applied to the Last Dollar Earned
The marginal tax bracket (MTB) is one of the six income-range segments that are taxed at increasing rates as income goes up. This is also called the marginal tax rate. Recall from Chapter 1 that the marginal tax rate is applied to your last dollar of earnings. Depending on their income, taxpayers fit into one of the six tax brackets (as shown in Table 4.1) and, accordingly, pay at one of those marginal tax rates: 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, or 35 percent. Each year the taxable income levels for
Taxes can be classified as progressive or regressive. The federal personal income tax is a progressive tax because the tax rate increases as a taxpayer’s taxable income increases. A higher income implies a greater ability to pay. As Table 4.1 shows, the higher portions of a taxpayer’s taxable income are taxed at increasingly higher rates under the federal income tax.* A regressive tax operates in the opposite way. That is, as income rises, the tax demands a decreasing proportion of a person’s income. An example is a state sales tax, since a rate of perhaps 5 percent might have to be paid by everyone regardless of income
The Marginal Tax Rate Is Applied to the Last Dollar Earned
The marginal tax bracket (MTB) is one of the six income-range segments that are taxed at increasing rates as income goes up. This is also called the marginal tax rate. Recall from Chapter 1 that the marginal tax rate is applied to your last dollar of earnings. Depending on their income, taxpayers fit into one of the six tax brackets (as shown in Table 4.1) and, accordingly, pay at one of those marginal tax rates: 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, or 35 percent. Each year the taxable income levels for
the tax brackets are adjusted to reduce the effects of inflation, a process called indexing Indexing keeps taxpayers from being unfairly forced to pay more taxes as they receive raises simply to keep up with inflation. Your marginal tax rate is perhaps the single most important concept in personal finance. It tells you the portion of any extra taxable earnings—from a raise, investment income, or money from a second job—you must pay in income taxes. Correspondingly, it measures the tax reduction benefits of a tax-deductible expense that allows you to reduce your taxable income. Consider this example of how the marginal tax rate might apply. Susan Bassett is from Syracuse, New York (see Figure 4.1). Part of her $60,000 gross income ($3400 $5350) is not taxed, the next $7825 is taxed at 10 percent, the next $24,025 is taxed at 15 percent, and the remaining $19,400 of Susan’s $60,000 taxable income is taxed at 25 percent. Thus, Susan is in the 25 percent marginal tax bracket because the last dollar that she earned is taxed at that level.
The Marginal Tax Rate Affects Your Financial Decisions
The marginal tax rate can affect many financial decisions that you make. Consider, for example, what happens if you are in the 25 percent marginal tax bracket and you make a $100 tax-deductible contribution to a charity. The charity receives the $100, and you deduct the $100 from your taxable income. This deduction results in a $25 reduction in your federal income tax ($100 0.25). In effect, you give $75 and the government “gives” $25 to the charity
The Marginal Tax Rate Affects Your Financial Decisions
The marginal tax rate can affect many financial decisions that you make. Consider, for example, what happens if you are in the 25 percent marginal tax bracket and you make a $100 tax-deductible contribution to a charity. The charity receives the $100, and you deduct the $100 from your taxable income. This deduction results in a $25 reduction in your federal income tax ($100 0.25). In effect, you give $75 and the government “gives” $25 to the charity
Your Effective Marginal Tax Rate Is Probably 43 Percent
The effective marginal tax rate describes a person’s total marginal tax rate on income after including federal, state, and local income taxes as well as Social Security and Medicare taxes. To determine your effective marginal tax rate on income, add all of these other taxes to your federal marginal tax rate. For example, a taxpayer might have a federal marginal income tax rate of 25 percent, a combined Social Security and Medicare tax rate of 7.65 percent, a state income tax rate of 6 percent, and a city income tax rate of 4 percent. These taxes result in an effective marginal tax rate of 43 percent (25 7.65 6 4 42.65, rounded to 43). Many employed taxpayers pay an effective marginal tax rate of 43 percent or higher
Your Average Tax Rate Is Lower
Many people wonder what proportion of their total income they pay in income taxes. Your average tax rate gives the answer to this question. For example, the average tax rate on Susan Bassett’s total income (the illustration in Figure 4.1) is 15.39 percent ($9236 $60,000), about the same for all U.S. taxpayers. Because total income is not fully taxed by the federal government, the average tax rate is always less than the marginal tax rate. But it is the marginal tax bracket that is most important because knowing what that rate is helps you make better financial decisions.
The effective marginal tax rate describes a person’s total marginal tax rate on income after including federal, state, and local income taxes as well as Social Security and Medicare taxes. To determine your effective marginal tax rate on income, add all of these other taxes to your federal marginal tax rate. For example, a taxpayer might have a federal marginal income tax rate of 25 percent, a combined Social Security and Medicare tax rate of 7.65 percent, a state income tax rate of 6 percent, and a city income tax rate of 4 percent. These taxes result in an effective marginal tax rate of 43 percent (25 7.65 6 4 42.65, rounded to 43). Many employed taxpayers pay an effective marginal tax rate of 43 percent or higher
Your Average Tax Rate Is Lower
Many people wonder what proportion of their total income they pay in income taxes. Your average tax rate gives the answer to this question. For example, the average tax rate on Susan Bassett’s total income (the illustration in Figure 4.1) is 15.39 percent ($9236 $60,000), about the same for all U.S. taxpayers. Because total income is not fully taxed by the federal government, the average tax rate is always less than the marginal tax rate. But it is the marginal tax bracket that is most important because knowing what that rate is helps you make better financial decisions.
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