November 8, 2013 by Aaron Scott Young
Do you know your marginal tax rate? More importantly, do you know your real tax rate? They are not the same, and knowing the difference can be critical to effective tax planning.
The U.S. individual income tax system is based on six tiers of rates: 10%, 15%, 25%, 28%, 33%, and 35%. A common misconception is that a taxpayer falls into just one of these brackets. But actually if someone’s income is high enough, their tax bill could be affected by all six. This is because the tax system is graduated, meaning the first taxable dollars are taxed at the lowest rates first, then move up the scale until the marginal rate is reached. Your marginal rate is the rate you will pay on your next dollar of taxable income. Your real tax rate (also called your effective tax rate) is the actual percent of tax you pay on your taxable income.
For example, the 10% rate is assessed on taxable income from $1 to $8,500 (if filing as single in 2011). The 15% bracket covers income from $8,501 to $34,500. If your taxable income is $30,000, your marginal (i.e., top tier) tax rate is 15%, but your real tax rate will be less because the first $8,500 of income is taxed at 10%.
Think of tax brackets as a row of buckets with one bucket for each bracket. Your income fills the lowest-rate bucket first, then the next bucket, then the next. Each bucket of income is taxed at its own specific rate. Entering the next bucket does not cause all your income to be taxed at the new rate, only the amount that flows over from the previous bucket. Your “top tax bracket” is the last bucket that has income in it, and that’s your marginal rate at which the next dollar you earn will be taxed.
There are other factors that can affect real tax rate. Personal exemptions and itemized or standard deductions can lower taxable income and thereby lower one’s overall rate. Conversely, unearned income such as interest and dividends might raise a taxpayer to a higher bracket. And some types of income are taxed differently from earned income. Long-term capital gains are taxed at 15% unless your ordinary income tax bracket is 10% or 15%, in which case long-term capital gains are not taxed at all.
Knowing where your income is in relation to the six brackets can make a big difference in keeping your real tax rate as low as possible.
Say for example your taxable income is sitting at $83,600, which is the top of the single 25% tax bracket. The next dollar you earn above that figure (up to $174,400) will be taxed at your marginal rate of 28%. So if the timing of a future receipt of income is within your control, such as from a pending business contract, consider deferring the income to next year. Another strategy might be to reduce taxable interest income by keeping money in a tax-exempt investment instead of a taxable one.
Or consider moving savings into Series EE savings bonds, where tax on the interest is deferred. You might also invest in longer-term CDs which pay interest in the next tax year. Or defer taking short-term capital gains until next year.
On the other hand if your income is just above a certain tax bracket, your strategy might be to look for deductions that will bring your income back down into the lower bracket. Options include such steps as contributing the maximum allowed to your 401(k) plan, your SEP, or your SIMPLE retirement plan. Another possibility is making a deductible IRA contribution for you and your spouse.
With the economy causing many household incomes to vary significantly from year to year, watching your marginal tax bracket is more important than ever. Contact our office today if you would like more information or a complete analysis of where you stand.