Your Money_ The Missing Manual - J. D. Roth [118]
On The Money: Marginal Tax Rates
Not all of your income is taxed the same; as you earn more, you pay more taxes. Your marginal tax rate is what you're taxed on the last dollar you earned. Confused? Here's a concrete example.
For the 2009 tax year, these were the tax rates for single filers making up to $171,550:
Taxable Income
2009 Tax Rates
Up to $8,350
10%
$8,351–$33,950
15%
$33,951–$82,250
25%
$82,251–$171,550
28%
Based on this table, if Gillian is single and had a taxable income of $100,000 in 2009, her marginal tax rate is 28%. However, this doesn't mean that all of her income is taxed at 28%—only the amount over $82,250 is taxed at that level. The fancy way to say this is that Gillian's income is taxed progressively at each bracket up to her marginal rate. That sounds confusing, but it's actually not so bad once you know what it means. Here's the breakdown:
The first $8,350 of Gillian's $100,000 income is taxed at 10% (see the table), so she owes $835 in taxes on that portion of her income.
The next $25,600 of her income (the amount from $8,351 to $33,950) is taxed at 15%, meaning she owes $3,840 in taxes on it.
The next $48,300 of her income (the amount from $33,951 to $82,250) is taxed at 25%, so she owes $12,075 in taxes on it.
The final $17,750 of her income (the amount from $82,251 to $100,000) is taxed at 28%, so she owes $4,970 in taxes on it.
Because Gillian earns $100,000 of taxable income, she's said to be in the 28% tax bracket based on the percentage she's taxed on the last dollar she earns. But as you can see above, most of her income is actually taxed at lower rates. In fact, she ended up owing a total of $21,720 in taxes in 2009, which means her effective tax rate was only 21.72%. (And her rate could actually be lower if she had any deductions and exemptions—see How Income Tax Works.)
This info may seem esoteric and unimportant, but understanding marginal tax rates can help you make decisions when investing or taking out a mortgage. Knowing about marginal rates can also help you understand why statements like, "If I take a second job, I won't benefit because it'll just push me into the next tax bracket" aren't true. As long as there's no 100% tax bracket, there's always a benefit to earning more money. To explore tax rates over time, check out this interactive calculator: http://tinyurl.com/usa-taxes.
Shift income and expenses
In some cases, you can save on taxes by shifting income from one year to the next. This doesn't work if you have a steady paycheck, but it can make a difference if you're self-employed or get paid irregularly. Say, for instance, you had more than usual income in 2009—enough to bump you up a tax bracket. In that case, if you were planning to sell some stocks, you might put it off until 2010 because you figure your marginal tax rate (see the box on Know what you owe) will be lower then.
You can apply this same principle elsewhere on your taxes. For example, you can use some expenses for itemized deductions if they're high enough. If you have medical expenses that total more than 7.5% of your AGI (How Income Tax Works) in a given year, for instance, you can deduct the amount that's over 7.5% of your AGI. To get above that amount, it can make sense to bunch medical expenses into a single year.
Note
While it's good to look for clever ways like this to reduce your taxes, never make life decisions based solely on the tax consequences. Don't put off heart surgery just to save on taxes, for instance.
Hire a pro
Some people are reluctant to hire others to do their taxes. If your taxes are really simple and you're good with numbers, then you may not need to hire a tax professional.
Tip
If you do your own taxes, you might be able to use Free File, a program that lets many U.S. taxpayers file their tax returns electronically at no cost. (For the 2009 tax