A Taxing Post
Posted on March 27, 2006 11 Comments
I just got my taxes back from H&R Block, where my aunt does them for free each year. The good news is that I’m getting more than $750 back. (I breathe a sigh of relief and begin dreaming of palm trees, new clothes, jewelry and shoes… only to be yanked back by the collective disappointment you all would feel if I splurged instead of saved. Damn you all! [Then I give you a big hug...thanks!])
The bad news, though, is that I appear to have reached a new income tax bracket. Last year my bracket was 15 percent, this year it’s 25 percent. And my return now shows that I pay an “effective tax bracket,” too, which was mysteriously missing from last year’s computations.
From what I gather, when most people talk about tax brackets (apparently some people do), they’re referring to the marginal income tax bracket. This “is the rate at which your last dollar of taxable income is taxed, not the rate at which all your dollars are taxed. It’s the maximum rate you’re paying on any of your dollars of taxable income” (Motley Fool, September 2001).
According to the literature, the marginal tax bracket is the maximum rate you can be taxed on any of your income dollars.
Now I’m kind of freaking out. Twenty-five percent of my income seems like a lot. No wonder I’m always broke! Uncle Sam, the biggest p-i-m-p out there, has increased his share of my earnings. Hmpf. Screw Uncle Pimp Daddy Sam. I’m moving to Canada.
But wait! Don’t move to Canada yet, Uncle Sammy pleads. And with good reason. As I noted, the marginal income tax bracket is the maximum rate I can be taxed. A better question to ask in hopes of understanding my tax return might be this: What’s the average tax rate I’m paying on my income? Ah. Now we’re talking. Enter the dashing effective tax bracket.
The effective tax bracket considers all the fluctuations that occur in your computation due to credits, dependents, retirement plans, etc. Here’s a great breakdown by the same Motley Fool article I referenced above:
An example
Mary is a single person. In 2001, if she has taxable income of $27,050 or less, her marginal tax rate will be 15%. But if her taxable income climbs to between $27,051 and $65,550, her marginal tax rate will be 27.5%. So if Mary has taxable income of $30,000, the first $27,050 of her taxable income would be taxed at 15% (resulting in a tax liability of $4,057.50), and the remaining $2,950 would be taxed at 27.5% (yielding an additional liability of $811.25). Add those sums together and you get Mary’s total tax liability: $4,868.75. But don’t forget that Mary most likely received her $300 tax refund early in 2001. So her actual tax amount for 2001 is $4,568.75.
When looking at the “big picture,” you should compute your “effective” tax rate. This is simply your total tax liability divided by your taxable income. In the example above, while Mary’s marginal tax bracket is 27.5%, her effective tax bracket is only 15.23% ($4,568.75 divided by $30,000 equals 0.1523). The effective rate tells Mary that most of her income is being taxed at the lower 10% and 15% brackets, and only a small portion is being taxed at the next (27.5%) bracket.
So, to summarize Mary’s tax situation:
- Mary’s marginal tax rate: 27.5%.
- Mary’s effective tax rate: 15.23%.
- Most of her dollars were taxed at the lower 10% and 15% tax rates.
- Her next dollars will be taxed at 27.5%.
Interesting, right? Well, in my case, H&R formulated my effective tax bracket for me. Mine turned out to be 12 percent. Whew! Turns out I’m not as beholden to Uncle Sam as I thought I was. (Wait a minute, so why am I always broke? There goes my excuse…)
If you don’t know your effective tax bracket, click here for some advice on how to calculate it, and learn about what it means to you.
PS- I don’t know why this post is affecting the formatting of my blog.
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11 Responses to “A Taxing Post”
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March 27th, 2006 @ 4:33 pm
don’t move to canada – you’d pay way more taxes there. What do you expect? They have universal health care.
March 27th, 2006 @ 5:17 pm
Then again, isn’t it nice to know you’re making the money that puts you in a 25% tax bracket?
Hope you find lots of deductions for next year!
March 27th, 2006 @ 6:47 pm
For British Columbia, Canada
0-~35000: 15% federal; 6% provincial
~35K-~66K: 22% federal; 9% provincial
I’m fudging the bounds of the brackets: each province & the feds sets the brackets slightly differently, but they’re usually within a couple grand of each other.
Of course that doesn’t take into consideration the money withheld for CPP (old age security) or EI ( [un]employment insurance). Nor does it take into consideration our lovely 7% federal goods & services tax.
March 27th, 2006 @ 8:09 pm
I’ll take universal health care over war any day. Wouldn’t it be nice if we could just assign our taxes to go to whatever government program we choose? Right now as I’m sitting here without health insurance, canada looks like a mighty-fine place.
March 27th, 2006 @ 8:15 pm
Thanks for the link Nicole! These tax brackets and the calculation always confuses me.
March 28th, 2006 @ 11:02 pm
Good points. Now you need to make it a priority to own a house or condo so you can itemize and reduce your effective tax rate further.
March 29th, 2006 @ 8:25 pm
Now you did it, you turned this post into a Canada vs. US, healthcare vs. war debate! Oh well. This was a great post. Common misconception, the tax brackets. Many are afraid of being bumped up to the next tax bracket. Of course, as you explained, that doesn’t change how each dollar earned up to that point is taxed.
March 30th, 2006 @ 5:38 pm
Who knew I had so many Canadian friends?
March 30th, 2006 @ 6:00 pm
When you add the Federal plus Provincial tax, Canada’s tax rates are higher than the US. It’s a good thing that you’re in a higher tax bracket. Congrats, you’re moving up! Next up…28% bracket.
March 31st, 2006 @ 4:27 pm
If you really want to calculate your effective tax rate, don’t forget to add in Social Security (6.2% of everything up to $90,000) and Medicare (1.45% of everything). These are the “hidden” taxes that people don’t normally think about, but for many of the middle-class, make up a substantial portion of their tax bill.
October 26th, 2008 @ 10:36 pm
So at my tax bracket (28%) with the maximum HSA contribution I can save $1666 off of the $15000-$25000 hospital bill (Note: the more money you make, the higher your tax bracket, the more money you’ll save with an HSA!