Tax Rates 101

There is a lot of talk about tax rates. Every way you turn the talking heads are mentioning them once again. Yet I venture to say the average person doesn’t fully understand how our tax system works. For example, a family making $100,000 a year may be especially terrified to learn their tax bracket may be raised from 25% to 28%. Quick head math: 3% more a year is $3,000 moreĀ  a year in taxes! However, it’s not that simple. Read on for your free Tax Rates 101 course.

Marginal Tax Rate vs Effective Tax Rate

The tax rate most often talked about (by the talking heads and co., as well as your neighbor and brother) is what is more correctly termed the marginal tax rate. Let me explain it the easiest way possible, the way one of my professors described it to me. I have also included a visual that I made (ehem) myself.

The man with the lightbulb is Bob, our money earner. Bob earns money. As his money comes in it fills the 10% bucket first. He will pay 10% taxes on that income. When that bucket fills up it spills over into the 20% bucket. He will then pay 20% taxes on that money. When that bucket fills up, it will spill into the bottomless (meaning it will never “fill up”) 30% bucket. Any money that makes it into that bucket will be taxes at 30%. Bob’s total taxes = 10% on the money in the first bucket + 20% of the money in the second bucket + 30% of the money in the third bucket.

Let’s say it is a good year and Bob makes enough money that it spills over all the way into the 30% bucket. Bob is in the 30% marginal tax bracket. Then suppose the next year is a not-so-good year and Bob’s money only makes it to the 20% bucket. Bob has now moved to the 20% marginal tax bracket. These are the tax rates that you hear talked about. The technical definition of a marginal tax rate is the amount of taxes paid on the next dollar earned. But I don’t know, I kind of like the bucket analogy better.

So what is an effective tax rate? It is hardly ever discussed. Maybe it’s not controversial enough. It is simply total income divided by total taxes paid. Basically the actual percentage of taxes one pays on their income.

Bob’s story is intentionally simplified for teaching purposes and does not take into account 100’s of possible factors, nor does it actually reflect the U.S. marginal tax rates. Above are the actual 2010 federal marginal tax rates. Of course this can be confusing to most people. But now all you have to do is imagine buckets.

(For 2011 federal marginal tax rates as well as a marginal tax rate calculator, go to this CPA Site Solutions page.)