Understanding Tax Brackets vs. Net Effective Tax Rate

Labrum Wealth Management writes: Have you ever heard someone say “extra income will throw me into the next tax bracket”? Understanding the difference between federal tax brackets and net effective tax rates might just help you make better investment decisions. Many people, including astute investors, seem to get confused with this concept.

What’s my tax rate?

Understanding the difference in your Federal Tax Bracket and your Net Effective Tax Rate might help you make better investment decisions.

The Definition of Tax Bracket is the rate at which an individual’s or corporation’s final dollar of income is taxed.  Tax brackets serve as cutoff points for given income tax rates: therefore, if an individual’s annual taxable income exceeds the cutoff point, that person is taxed according to the next tax bracket.

According to Investopedia, the Net Effective Tax Rate is the average rate at which an individual or corporation is taxed. For more info. click

here: http://www.investopedia.com/terms/e/effectivetaxrate.asp

The 2014 US Federal Tax Brackets are as follows:

Rate Single Filers Married Joint Filers Head of Household Filers 10% $0 to $9,075 $0 to $18,150 $0 to $12,950 15% $9,076 to $36,900 $18,151 to$73,800 $12,951 to $49,400 25% $36,901 to $89,350 $73,801 to $148,850 $49,401 to $127,550 28% $89,351 to $186,350 $148,851 to $226,850 $127,551 to $206,600 33% $186,351 to $405,100 $226,851 to $405,100 $206,601 to $405,100 35% $405,101 to 406,750 $405,101 to 457,600 $405,101 to $432,200 39.6% $406,751+ $457,601+ $432,201+

Let’s take a look at an Example:

A married couple filing jointly has $227,000 in taxable income and falls into the 33% Tax Bracket. How are they taxed?  Simple math would say $227,000 X 33% = $74,910 in federal tax. Right? Not so fast. A closer look would help us to see that even though this couple earned $227,000 they did NOT pay 33% tax on all of their income.

In fact, they paid to following:

10% tax on the first $18,150 they earned,

25% from $18,151 to $73,800, and

28% $148,851 through $226,850.

It’s not until $226,851 that they paid 33%.

*Since they made $227,000, only $149.00 was taxed at 33%.

Taking the average of all of the rates they paid will give us their net effective tax rate of 22.4%

Now you can save some extra money since you might actually be paying less tax than you thought you were.

In summary, your tax bracket is the rate at which your last dollar earned was taxed and your actual tax rate is the average of all the tax brackets you paid. We hope this serves as another arrow in your quiver of intelligent wealth management.