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A Message from Kimberly Clouse, Financial Expert:
I have worked in the financial services industry for
nearly a decade in many capacities, most recently as
a financial advisor for individuals. Over the course
of my career, I have had the privilege of working with
a diverse range of people, from the single mother just
starting her own business to the dot.com billionaire.
Based upon my experiences, I have learned that the same
basic principles and lessons apply to a successful and
healthy financial life, whether you're starting out
or cashing out. These guiding principles include simplicity,
a long-term perspective, and above all, knowing that
you have control of your financial destiny, and all
the information you need is well within your reach.
Taxing Matters
Taxes tend to make people’s eyes glaze over. Nonetheless,
it is important to know your marginal tax rate when making
investment decisions. For instance, the cost of selling a
stock held for less than a year will be higher for someone
in the 31% bracket than for someone in the 28% bracket. Also,
the higher your tax bracket, the more appealing investments
like tax-free municipal bonds become.
Before we launch into the differences between marginal and
effective rates, let’s discuss two definitions that are
helpful when thinking about the tax that you actually pay
on your income:
- Gross income is your total income from all sources, unless
specifically excluded by tax law (e.g., tax-exempt bond
interest).
- Taxable income is calculated by subtracting all your allowable
adjustments, deductions, and exemptions from gross income.
Tax rates are applied to taxable income to determine how
much tax is due.
Two tax rates are important in understanding how your income
is taxed: your marginal tax rate and your effective tax rate.
- Marginal tax rate is the rate applied on your last dollar
of earnings. To illustrate this concept, assume that the
tax system only has two rates: 10% on the first $20,000
of income and 20% on income in excess of $20,000. If you
received a salary of $25,000 and a bonus of $2,500, your
marginal tax rate on the bonus (and $5,000 of your salary)
is 20%. Your marginal rate will also tell you the effective
tax savings of deductions. For example, a $1,000 deduction
for someone with a marginal tax rate of 28% gives an effective
tax savings of $280 ($1,000 x 0.28).
- Effective tax rate is calculated by dividing the total
tax paid by your total income and is therefore the overall
rate at which your income is taxed. Using the example above:
- Your total income is $27,500 ($25,000 salary + $2,500
bonus).
- The tax on your first $20,000 of income is $2,000
($20,000 x 10%).
- The tax on the next $7,500 is $1,500 ($7,500 x 20%).
- So the total tax due is $3,500 ($2,000 + $1,500).
- Therefore, the effective tax rate is only 13%, or
$3,500 total tax divided by $27,500 total income. Compare
this with the 20% top marginal tax rate in this example.
Marginal tax rates result from the IRS’ graduated tax
system, and people pay an increasing percentage as their income
rises through various brackets. Simply put, the IRS charges
different tax rates for different levels of your taxable income.
In general, at the federal level, taxpayers fall into 5 marginal
tax brackets.
For an example, in 1999, those tax brackets were: 15%, 28%, 31%, 36% and 39.6%. Check with www.irs.gov for this years' current deductions. (While most Americans
fall into one of the 5 tiers, for some people, the top tax
rate effectively exceeds 39.6%, as itemized deductions and
exemptions are phased out beyond certain income levels.)
In this tiered tax system, you pay 15% on the first tier
of taxable income--for a single person in 1999, the first
$25,750 in earnings. You pay 28% in taxes on the next tier--again,
for a single person in 1999, this applies to income between
$25,750 and $62,450. In accordance with the marginal tax system,
you pay increasing percentages as your income rises, reaching
a 39.6% rate on all income over $283,150. Refer to the sample chart below from the year 1999. Should you want to learn
more about your particular tax rate for the current year and their effect on
your financial situation, visit the official Web site of the Internal
Revenue Service, www.irs.gov.
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Single
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Married filing joint or surviving spouse
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Head of household
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Married filing separately
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15% if your taxable income is over:
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$ 0
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$ 0
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$ 0
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$ 0
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28% if your taxable income is over:
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$ 25,750
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$ 43,050
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$ 34,550
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$ 21,525
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31% if your taxable income is over:
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$ 62,450
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$104,050
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$ 89,150
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$ 52,025
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36% if your taxable income is over:
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$130,250
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$158,550
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$144,400
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$ 79,275
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39.6% if your taxable income is over:
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$283,150
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$283,150
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$283,150
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$141,575
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Should you want to learn more about tax rates and their effect
on your financial situation, visit the official Web site of
the Internal
Revenue Service.
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