Understanding Marginal Tax Rates

by Dual Income No Kids on September 10, 2008 · 0 comments

Taxation. While many people find the topic of income taxes to be dull and uninteresting, understanding how they work can have a powerful impact on your bottom line.

So this posting addresses income tax rates, specifically federal income tax rates. First, some definitions.

Marginal Tax Rates: The sad truth is that not all dollars are taxed equally. The marginal tax rate is the rate you pay on your last or highest dollar of income.

Taxable Income: The amount of your income on which you actually pay taxes.

In 2008 your tax amount is defined by the highest dollar amount of your taxable income. Here is how this works: if your filing status is single and you earned $45,000 then your taxes would be in the $32,550 to $78,850 bracket (see table below). This means your tax would be $4,481 plus 25% of the difference between the lowest rung of the bracket and your taxable income. These numbers look a bit different from previous years so here are the calculations. Your tax is (your income – lower value of marginal tax rate* percentage you owe). In this example, ($45,000 – $32,550) *.25 or ~ $3,112.5. Add the $4,481 to $3,112.5 and your bill to Uncle Sam is $7,593.5. Voila.

As per the IRS, the 2008 rates are:

Why Should You Care?

One word: money. For most people, federal income taxes are their single largest expenditure. The key to reducing your tax payment is to reduce your taxable income. For the table above, its clear that if you reduce your taxable income to a lower bracket, you pay less. For example, if your taxable income is lowered from over to under $32,550 you’ll only have to cough up 15%, not 25% – a big difference.

The best way to reduce your taxable income is take advantage of existing opportunities such as maxing out your 401k, contributing to an IRA, taking your mortgage interest deductions, etc. You might also consider itemizing, trading consumer debt for mortgage debt or increasing the amount of charitable contributions and expenses you incur.



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