Before we get into the various tax brackets for 2010, we should take a second to understand what a tax bracket is. Its a common misconception that your tax bracket is the percentage of your income paid in federal income tax. Have you ever had a conversation where a relative warns you, Dont make more than $34,000, theyll tax it all at a higher rate! Not to step on your familys good intentions, but thats not quite how it works.
A tax bracket is what determines your marginal tax rate, the percentage amount paid in taxes on a taxpayers last dollar earned. In the example above, wages earned from $1 and $8,375 are taxed at 10% and wages between $8,376 and $34,000 are taxed at a rate of 15%. The next brackets rate is 25%. Taxable dollars earned above $34,000 are taxed at 25%.
So, despite what your well-intentioned uncle or aunt insists, you wont pay 25% of your wages if you make $34,001. (Youll pay 25% on that last dollar.) This in addition to the taxes you pay for Social Security and Medicare (7.65% if youre a wage earning employee, 15.3% if youre self-employed) and any state income taxes.
Now that weve cleared that up, lets take a look at marginal tax rates for 2010:
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The rates you see above have been the same since 2003. In 2002, the highest four brackets paid a little more: 27%, 30%, 35%, and 38.6%. In the year previous, 27.5%, 30.5%, 35.5%, and 39.1%. There is talk of changing the brackets so that the second top bracket begins at $200,000, and the top two pay 36% and 39.6% on their last dollar earned.
Why should you be familiar with your tax bracket, especially when Turbo Tax or H&R Block handles your taxes for you? Knowing how much money in taxes you pay on your last dollar earned is valuable in a number of financial decisions. Say for example youre offered a job that pays $3,000 more than you currently make, but learn that the employer is 30 minutes farther away.
Knowing whether youll pay 15, 25, or 35 percent impacts your decision. That job will cost you an extra five hours of commute each week, plus any additional costs to go the extra distance. If your marginal tax rate is 15%, and the commute carries no extra cost, that $2,550 of post tax income is probably worth it. If your marginal rate is 28% and you drive a Hummer to work, you might wind up spending most of your 2,160 post-tax dollars on gas for the commute.
Knowing your marginal tax rate also helps you make informed decisions about tax-deductible investments. You can save up to $5,000 per year in a traditional or Roth IRA. The difference? Youll contribute to the traditional IRA with pre-tax dollars, and pay taxes when you withdraw the money during retirement; the Roth contribution is paid post-tax, but interest accrues tax-free, and you wont spend a dime in taxes when you withdraw for retirement expenses. Whatever your income level or financial goals, your tax-bracket is one piece of information you cant afford not to know.