Understanding Tax Brackets

What better time is there to ponder taxes than now, when tax season is upon us and in full swing? While some of us are still deciding between employing Turbo Tax, H & R Block or our college buddy who kinda dabbled in accounting, here's a bit of tax-related reading dedicated to marginal taxes.

There seems to be a bit of a misconception floating around out there about income levels and taxes. The more you make, the higher the income bracket, and that means Uncle Sam gets a huge check from you. Right? Not entirely true. While bringing in an income means you will have to pay taxes, it does not necessarily mean that the whole bulk of the income will be taxed at the same rate - especially if you're bringing in a larger income.

Since there are a few factors involved here, an easy way to explain marginal taxes is to take a look at them "in action." Let's use Sheldon Cooper (one of my favorite TV characters) an example. We'll say that last year his income amounted to $100,000. Now, if you look at tax brackets from 2010, you might be tricked into thinking that his whole income would be taxed at 25%, and that he would owe $25,000 in taxes. Not so. Here's where marginal taxes come into play.

Sheldon's marginal tax would be at 25%, but his whole income is not assessed at this level. Marginal taxes are just that - a tax rate on the top portion of an income. Based on the tax brackets, a certain amount of the income will be taxed at the lowest rate, then the next rate, and so on. Whatever bracket his income falls into is where his marginal tax rate would be.

For grins and giggles, what could Sheldon expect to pay in taxes? The first $8,375 would be taxed at 10% ($837.50). The next $25,625 would be taxed at the 15% rate($3,843.75), the next $42,400 at 25% ($12,075) and the last $17,600 at 28% ($4,928), the highest rate for his income level, and also the marginal tax rate for his income level. Most of his income was taxed at levels lower than the 28%; it was only the last part of his income that fell into the 28% tax bracket and was taxed at that rate.

What this means in practice is that everyone pays the same amount of tax on the first $8,375 they make. Then everyone pays the same on the next $25,625. There's never a point where making an extra dollar costs you more money. Some people are confused about this, so rest assured that it's safe to go out there and earn as much as you can.

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