Reduce Taxable IncomeOne of the biggest sources of confusion when it comes to taxes is the rate at which we are taxed. At first glance, it seems fairly straightforward: Your tax bracket determines how much you are taxed. If you make $100,000 a year, you fall into the 28% tax bracket, so you owe $28,000, right?

Not so fast. Before you get to the point of deciding how much you owe in taxes, there are a few steps to go through.

Reducing Your Taxable Income

First of all, it is important to understand that your tax bracket is determined by your taxable income. If you make $100,000 a year, that entire amount isn’t going to be taxed. In fact, after you account for your deductions and exemptions, instead of being taxed on your $100,000 gross income, you are likely to be taxed on between $65,000 and $75,000 (depending on how your income is reduced). This amount is known as your taxable income. If you have enough deductions to put you at around $67,000 in income, and you are married filing jointly, you are in the 15% tax bracket – not the 28%.

But, even in this case, your taxes aren’t figured by taking 15% of that $67,000. Marginal tax rates don’t work like that.

Marginal Tax Rates

In actuality, all of your income is taxed at a different rate, progressing from the lowest bracket, up through your marginal tax bracket. So, if you are in the 15% tax bracket, some of your income is taxed at 10%, and some at 15%.

Marginal Tax Rates

 

Above, you can see a table with 2011 marginal tax brackets. If you have $67,000 in taxable income, and you are married filing jointly, here’s how it would work:

  • Your income up to $17,000 is taxed at 10%, totaling $1,700
  • Your remaining income ($50,000) is taxed at 15%, totaling $7,500
  • Add the two, and your tax is $9,200

In reality, you are only paying 9.2% of your gross income in taxes. The same principle works for someone in a higher tax bracket as well. What if that $100,000 was your taxable income, rather than your gross? In that case, you would progress through the tax brackets as follows:

  • Income up to $17,000 taxed at 10%: $1,700
  • The next $52,000 of income (bringing it up to $69,000) at 15%: $10,350
  • Final $31,000 of income at 25%: $7,750
  • Total Tax = $19,800

So, even though someone making $100,000 in taxable income is in the 25% tax bracket, he or she is paying a smaller portion of that in taxes – 19.8% of taxable income. If his or her gross income were larger, at $120,000 a year, the true percentage of income paid in taxes would be lower: 16.5%.

If you don’t understand how marginal tax rates work, it can be misleading to see your tax bracket. And, because of the way income is taxed in our system, moving up a tax bracket does have as big of impact as many would think. In our example of $67,000 in taxable income, if the earner made $71,000 instead, moving up to the 25% tax bracket, the addition to his or her taxes would be $3,350, bringing the total to $12,550, or 12.55% of the gross $100,000 income. It’s a lot gentler than jumping from paying 15% on $67,000 to paying 25% on $71,000, which would be a difference of $7,700.

Bottom Line

Understand how marginal tax rates work, and you will have a better understanding of how you are taxed.