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What every tax payer should know about marginal tax brackets

Many people get confused with marginal tax brackets, although, in effect, they are pretty straightforward. Tax bracket is the rate tax payers pay on the last dollar they earn. Because taxable income falls into a progressive tax structure where different tax rates are assigned, in effect, the marginal tax bracket is the marginal tax rate. Broadly speaking, the first dollar every taxpayer earns is taxed lower than the last dollar earned.

For every taxpayer, the taxable income is not the salary he receives every month, but the amount of income left after the 401k and IRA contributions and the tax breaks he is entitled are deducted. Tax brackets are defined based on the income ranges that change every year depending on the filling status of the taxpayer (single, married filling jointly, married filling separately, head of the household) and the relative adjustments to account for inflation.

To illustrate how tax brackets work, we assume that a taxpayer, who is single, files $90,000 in taxable income in 2009 for the 2008 tax year. According to the income ranges that define tax brackets, the first $8,025 of this taxpayer’s income is taxed at 10 percent; income between $8,025 and $32,550 is taxed at 15 percent; income between $32,551 and $78,850 is taxed at 25 percent; income between $78,851 and $80,000 is taxed at 28 percent.

Therefore:

[($8,025 – 0) x 10%]  + [($32,550 - $8,025) x 15%] + [($65,725 - $32,550) x 25%] + [($90,000 - $65,725) x 28%] = $802.50 + $3,678.75 + $8,293.75 + $6,797.00 = $19,572.00

Hence, a single filer that reported $90,000 for the 2008 tax year belongs to the highest tax bracket of 28%. Yet, as a percentage of his whole income, the tax is 19.57%.

Tax preparers suggest that the general rule for having a taxable income on a lower tax bracket and paying lower taxes on the next earned dollar is to contribute to 401k account to match what the company contributes to it. In effect, the more money a tax payer makes, the less credits and reductions he is entitled to. Therefore, an effective way to control the income level is by making 401k and IRA contributions in order to reduce taxable income as much as possible to get into the lowest bracket.

Another way to lower the annual taxable income is through adjustments to gross income, commonly referred to as A.G.I. These adjustments are available to all taxpayers and include moving expenses, student loan interest, retirement contributions etc. These adjustments are known as above-the-line deductions because they appear above the line for adjusted gross income on tax return. There are also the below-the-line deductions that include standard deductions deriving from the filling status (single, married filling jointly, married filling separately, head of the household).

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October 23rd, 2009 | Category: Personal Finance | Comments Off
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