It is interesting to know that consumers feel that their income is taxed uniformly throughout. However, this is not true and consumers must understand tax basics. Different amounts are taxed a different taxation rates. Put simply the marginal tax rate for an individual is the tax bracket at which his/her highest portion of income is taxed. So in essence when people talk about their income tax brackets, what they are actually talking about is their marginal tax rates.

Below is an example to help you understand the determination of your tax bracket:

Tax Bracket Calculator

Let us assume that your Gross Wage Income for the 2008 income year to be filed in 2009 is $120,000.00. Now the question arises as to how will the income tax liability on your income be calculated.

• The first $8,350 will be taxed at 10%. $8,351-$33,950 will be taxed at 15%.
• The amount from $33,951-$82,250 will be taxed at 25% and the amount between $82,250-$120,000 will be taxed at 28%.
• This will give you a total tax liability of $835 + $3,840 + $12,075 + $10,570 = $27,320.
• Hence your marginal tax rate in this instance is 28%, because that is the rate at which your highest income is taxed.

One of the main reasons to use a marginal tax rate is to calculate the amount by which a deductions will reduce your income. For instance if your marginal tax rate as in this case is 28%, for every $100 deduction that you claim your taxable income will be reduced by $28 ($100 x 0.28).

Effective Tax Rate

Another interesting concept in determining your tax bracket is understanding what your effective rate of taxes is. The effective tax rate of an individual is the total amount of an individual’s income which has been paid in taxes. Effective rate is calculated as below:

Let us assume the above example. In this case the total taxes due are $27,320. The consumer’s gross income for the year was $120,000. In this case the effective rate would be $27,320/$120,000 = 0.2276 or 22.77%.

When trying to uderstand your tax bracket, always remember that your effective rate will always be lower than your marginal rate owing to the fact that you have been paying taxes at lower rates all the way through to your marginal tax rate.

Combined Tax Rate

Another interesting rate to keep in mind is the combined rate. The combined tax rate for an individual is the marginal tax rate for an individual plus the state tax rate minus any state taxes that can be deducted from your federal tax returns. In the above example the combined rate would be 33% (28% + 5%) should you opt for standard deductions. The main purpose of calculating your combined rate is that it enables you to understand the amount of your non-wage related income that you can keep and what your tax liability is. Put simply it tells you how much of your investment income is going to be taxed and how much can you retain. In this example if you earned $10,000 in investment income, you would be paying $3,300 in taxes and would retain $6,700.

These are some of the basic concepts on how to determine your individual tax bracket and there by calculate your tax liability. So when you consider the fact that your taxable income is exactly what was on your contract, this may be wrong as it is usually your income left over after making contributions to 401(K) account and deducting the tax breaks you are entitled to.

References:

1. So what’s your tax bracket? – CNN Money
2. Federal tax brackets – Money Chimp