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 35% bracket than for someone in the 25% 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 6 marginal tax brackets.

For an example, in 2005, those tax brackets were: 10%, 15%, 25%, 28%, 33% and 35%. While most Americans fall into one of the 5 tiers, for some people, the top tax rate effectively exceeds 35%, as itemized deductions and exemptions are phased out beyond certain income levels.)

In this tiered tax system, you pay 10% on the first tier of taxable income--for a single person in 2005, the first $7,300 in earnings. You pay 158% in taxes on the next tier--again, for a single person in 2005, this applies to income between $7,300 and $29,500. In accordance with the marginal tax system, you pay increasing percentages as your income rises, reaching a 35% rate on all income over $326,450. Refer to the sample chart below from the year 2005. 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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