Do you know your marginal tax rate?

More impor­tantly, do you know your real tax rate? They are not the same, and knowing the difference can be critical to effective tax planning.

The U.S. individual income tax system is based on six tiers of rates: 10%, 15%, 25%, 28%, 33%, and 35%. A common mis­conception is that a taxpayer falls into just one of these brackets. But actually if someone's income is high enough, their tax bill could be affected by all six. This is because the tax system is graduated, meaning the first taxable dollars are taxed at the lowest rates first, then move up the scale until the marginal rate is reached. Your marginal rate is the rate you will pay on your next dollar of taxable income. Your real tax rate (also called your effective tax rate) is the actual percent of tax you pay on your tax­able income.

For example, the 10% rate is assessed on taxable income from $1 to $8,500 (if filing as single in 2011). The 15% bracket covers income from $8,501 to $34,500. If your taxable income is $30,000, your marginal (i.e., top tier) tax rate is 15%, but your real tax rate will be less because the first $8,500 of income is taxed at 10%.


Think of tax brackets as a row of buckets with one bucket for each bracket. Your income fills the lowest-rate bucket first, then the next bucket, then the next. Each bucket of income is taxed at its own specific rate. Entering the next bucket does not cause all your income to be taxed at the new rate, only the amount that flows over from the previous bucket. Your "top tax bracket" is the last bucket that has income in it, and that's your marginal rate at which the next dollar you earn will be taxed.