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Your Tax Bracket
"What's my tax bracket?" is a very important–and commonly asked–
question. First, it lets you know how much tax you must pay the
government, and second, it affects how much after-tax savings
certain deductions can generate, as well as how much after-tax
return certain investments generate, under current 2000 rules.
In actual fact, there are two important tax brackets for everyone:
Your effective, Overall Tax Bracket, and your Marginal Tax Bracket.
Your Overall Tax Bracket
This is exactly as it sounds; it's an average figure based on the
total amount of tax you pay compared to your gross taxable income.
Thus, if you paid $5,000 in federal taxes, and your gross taxable
income was $33,400 as a married filer, your Overall Tax Bracket
would be 15%. In effect, you paid 15% of your gross taxable income
to the federal government. So, everything else being equal, you
could budget that amount as your reserve for federal taxes.
The same type of analysis applies for state income taxes paid. If
your state tax amounted to $1,000 in the above example, your state
Overall Tax Bracket would be 3% before allowance for federal
deductibility of these state taxes.
Your Marginal Tax Bracket
This bracket is very important for tax planning purposes. In effect,
it is the tax rate you pay on the last dollar of net taxable income,
hence the term "marginal." Under our current tax laws, there are
several tax brackets; the more money you make, the higher the tax
for that portion–or bracket–of money. For instance, a single
individual with a taxable income of $65,000 would pay federal tax as
follows: 15% on the first $25,750, 28% on the next $36,700, and 31%
on the remaining $2,550, based on the 1999 tax rate schedules.
Thus, in this example, the marginal bracket would be 31%, and the
taxpayer would pay 31 cents on every extra dollar earned above the
$62,450 level already being taxed. It also means this taxpayer would
save 31 cents on every extra dollar of tax deductions at this level.
Examples of these allowable federal deductions are such items as
interest expense, donations, taxes, medical, and miscellaneous
business expenses, to name a few. Taxpayers who also have deductions
in such areas as rental property, capital losses, retirement plan
deductions, and businesses of their own follow the same pattern.
Finally, this marginal bracket is important in evaluating the true
return on different types of investments. By analyzing the gross
income from the investment vs. the actual, after-tax yield, a
"common denominator" can be found among various investments. So, if
the taxpayer in the example we used made an extra investment that
yielded 10%, the actual, after-tax yield on this from a marginal tax
bracket standpoint would be 10% less the 31% tax, or 6.9%.
Let's use dollars to make the conceptualization easier. Assume you
make an investment that costs $10,000 and returns $1,000(10%) in
taxable income. If your marginal tax rate is 31%, then $310 must be
paid in taxes, leaving $690, or 6.9%.
Again, the same type of analysis applies to state taxes paid on a
marginal basis. This becomes especially important from an after-tax
analysis in comparing taxable vs tax-free investments such as
municipal bonds, or U.S. obligations such as treasuries.
In fact, the state marginal tax bracket can be defined even more
technically when you assume that state income taxes will be
deductible on the federal tax return. In this case, the state taxes
are actually less because of the federal tax savings due to their
deductibility. As an example, if your state marginal tax bracket
were 4%, and your federal marginal tax bracket were 31%, than the
actual state, after-federal-tax marginal bracket would be 3.69%
which is the 4% less the federal tax savings of 31 cents on the
dollar of deductions.
As you can see, the higher your income, the higher the marginal tax
rate, and the more important this after-tax analysis becomes when it
concerns your deductions, or your investments.
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