Wow, does that mean if we make $500,000 we’ll pay $198,000 in federal income tax?
The rates you hear on the news are the top marginal tax rates. Tax payers are divided into tax brackets, which determine which rate taxable income is taxed.
Federal Tax Brackets
The 2012 rates for a married couple filing jointly are as follows:
- 10% on taxable income from $0 to $17,400, plus
- 15% on taxable income over $17,400 to $70,700, plus
- 25% on taxable income over $70,700 to $142,700, plus
- 28% on taxable income over $142,700 to $217,450, plus
- 33% on taxable income over $217,450 to $388,350, plus
- 35% on taxable income over $388,350.
So for the couple above, only the income over $388,350 – $111,650 – would be taxed at 35%?
In theory, yes.
But keep in mind that only the taxable income – not gross income – is taxed. Many people reduce their taxable income considerably by itemizing deductions and/or making contributions to retirement accounts.
Average Tax Rate
The average tax rate is just that, the total amount of tax divided by total income. To use a nice round number, let’s say the couple above has $500,000 of taxable income. What is their average tax rate?
The average rate in this (simplified) example* is 29%. That is still a lot of taxes, but a bit different from 35%.
Don’t use these examples to try and calculate your own taxes. Every situation has its own details, and marginal rates interact with other tax rates, including the alternative minimum tax, Social Security tax, and Medicare tax rates.
The point is simply that there is a big difference between the marginal rate and the effective average rate that you will end up paying. You may be pleasantly surprised.
Please note, changes in tax laws may occur at any time and could have substantial impact upon each person’s situation. You should discuss tax or legal matters with the appropriate professional.
The information contained in this report does not purport to be a complete description of the securities, markets or developments referred to in this material.
photo credit: Alan Cleaver via photopin cc