How Tax Brackets Work
You might be on your last dollar, but it’s not always a reason to sing the blues. In fact, in the strange world of taxation, your last dollar could actually put you in a higher tax bracket. Put on your shades, grab your guitar, and read on.
A tax bracket is a range of incomes taxed at a specific rate. For example, the lowest tax bracket might be $0-$8,025; the second might be $8,026-$32,550; the third $32,551-$78,850. When your income moves above or below the range limits (from $8,025 to $8,026 for example), you switch to a different tax bracket.
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Tax brackets are components of a progressive income tax system, in which taxes increase progressively as income increases. The idea is that high-income taxpayers can shoulder the burden of a high tax rate. Low-income taxpayers pay less because they can't afford to pay high taxes.
Tax bracket is a simpler way to say marginal tax rate. A marginal tax rate is the "tax paid on an additional dollar of income" [source: Investopedia]. That additional dollar is also known as your "last dollar." In a progressive tax system, the portion of your income that does not exceed the upper limit of a tax bracket is your "last dollar."
In this article, you'll learn where your last dollars fall. You'll find out how to find your U.S. tax bracket and learn a little about the history of tax brackets in the United States.
Helpful Tax Resources
Little changes can make a huge difference when it comes to your tax return. These articles will help you get the most from your return (and make the whole process as easy as possible).
- 10 Tax Questions You Probably Don't Ask
- 10 Tips to Avoid an IRS Audit
- 2014 Tax Brackets
- How Your W-2 Works
- How the IRS E-file Process Works
presented by TaxACT
Finding Your Tax Bracket
Finding your tax bracket is actually pretty easy. First you need to know your taxable income. Taxable income is your adjusted gross income (AGI) minus your standard or itemized deductions.
Let's put this into a working example we'll use throughout the section:
Karen's taxable income is $70,000.
Next you need to know your filing status:
- Single
- Head of household
- Married filing jointly or Qualifying widow(er)
- Married filing separately
Karen is single.
Next is the tax bracket. In the 2008 tax year, there are six tax brackets for each filing status. Since Karen is filing single, she would look at IRS Schedule X, which lists the tax rates for people who file single:
Single
Karen's taxable income of $70,000 falls into the third tax bracket, so she has a tax rate of 25 percent.
At first glance, Karen thinks that her $70,000 will be taxed at 25 percent. Fortunately for her, that's not how a progressive tax rate works.
Karen's income will be taxed as it progresses through the tax brackets. So, her first $8,025 is taxed at a rate of 10 percent. Her income that falls in the second bracket will be taxed at 15 percent. Her "last dollar" lands in the third bracket. The portion of her income that falls into that third bracket ($37,450) will be taxed at 25 percent. Here are the calculations:
First Bracket: $8,025 x 0.10 = $802.50
Second Bracket: ($32,550 - $8,025) x 0.15 = $3,678.75
Third Bracket: ($70,000 taxable income - $32,550) x 0.25 = $9,362.50
Total Tax: $802.50 + $3,678.75 + $9,362.50 = $13,843.75Total Tax: $802.50 + $3,678.75 + $9,362.50 = $13,843.75
A Second Example: Let's say Raoul and Gretchen are married. Their combined taxable income is $200,000. They file a joint tax return, so they consult IRS Schedule Y-1:
Married filing jointly
- $0 to $16,050 -- 10 percent
- $16,050 to $65,100 -- 15 percent
- $65,100 to $131,450 -- 25 percent
- $131,450 to $200,300 -- 28 percent
- $200,300 to $357,700 -- 33 percent
- Over $357,700 -- 35 percent [source: IRS]
Raoul and Gretchen's taxable income of $201,000 falls into the fifth income tax bracket. Here are the calculations for their tax:
First Bracket: $16,050 x 0.10 = $1,605
Second Bracket: ($65,100 - $16,050) x 0.15 = $7,357.50
Third Bracket: ($131,450 - $65,100) x 0.25 = $16,587.50
Fourth Bracket: ($200,300 - $131,450) x 0.28 = $19,278
Fifth Bracket: ($201,000 taxable income - $200,300) x 0.33 = $231
Total Tax: $1,605 + $7,357.50 +$16,587.50 + $19,278 + $231 = $45,059Total Tax: $1,605 + $7,357.50 +$16,587.50 + $19,278 + $231 = $45,059
Raoul and Gretchen's taxable income is $700 over the fourth bracket's upper limit. That final $700 is taxed at 33 percent, or 5 percent higher than the next lowest rate. To stay out of the fifth bracket, they might consider looking for additional deductions to decrease their taxable income.
A $45,059 tax bill seems like quite a hit. But imagine being in a 94 percent tax bracket. It's happened to U.S. citizens -- in living memory. Read on to learn about the history of income tax brackets.
Effective Tax RateTo find your effective tax rate, or your overall tax rate, divide your total tax by your taxable income. [source: The Motley Fool] Karen's effective tax rate is approximately 20 percent.
Tax Bracket History
Colonial and early U.S. taxes went through various changes until the first income tax was established by the Revenue Act of 1861. The purpose of this income tax was to help the Union raise money to fight the Civil War against the Confederacy. This income tax affected incomes of $800 and up at a rate of 3 percent.
The first tax brackets came about in 1862. The lower tax bracket was 3 percent for income up to $10,000; the higher tax bracket was 5 percent for income over $10,000. In 1872, this income tax was repealed. Since the Civil War ended, the government no longer needed the money.
The U.S. Constitution gave the federal government the power to levy taxes "in proportion to each State's population" [source: U.S. Department of the Treasury]. When the federal government established an income tax in the 1890s, the Supreme Court declared the tax unconstitutional, because it disregarded state populations.
In 1913, the 16th Amendment to the Constitution gave the government the power to levy an income tax regardless of state population. The federal income tax has been in place ever since.
Here are some important dates in the history of the federal income tax and its tax brackets.
- 1913: Tax brackets range from 1 percent on income of $0-$20,000 to 7 percent on income of $500,000 and higher.
- 1916: Revenue Act increases rates. Tax brackets range from 2 percent to 15 percent.
- 1917: War Revenue Act of 1917 increases rates. Tax brackets range from 2 percent on income of $0-$2,000 to 67percent on income of $2 million and higher.
- 1920s: Tax rates are cut because the economy is doing well. The highest marginal rate decreases to 25 percent.
- 1930s: Big increases because of the Great Depression. Lowest rate is 4 percent. Highest rate is 79 percent. Income of $90,000-$100,000 is taxed at 59 percent. In 1933, there are 55 tax brackets, mostly in 1 percent increments.
- World War II: Great tax increases to fund the war. The lowest rate in 1944 is 23 percent, for income of $2,000 or less. The highest rate is 94 percent for income of $200,000 or more.
- 1981: Economic Recovery Tax Cut of 1981 lowers tax rates. Highest tax rate drops from 70 percent to 50 percent.
- 1986: Tax Reform Act of 1986 reduces rates further and cuts the number of brackets. For the 1986 tax year there are 15 tax brackets. For 1987, there are five. [source: The Tax Foundation]
In the 1980s, economists argued that high tax rates dissuaded people from working hard. The tax changes in the 1980s, then, were meant to encourage economic growth. Tax rates have fluctuated since then, but the simplified tax bracket system has changed very little.
If you'd like to know more about tax brackets and related topics, you can follow the links on the next page.
Unlawful IncomeIn the early days of the modern income tax, the tax law stated that the tax covered "lawful income." In 1916, the word "lawful" was deleted. Effectively, illegal income, such as stolen money, was subject to income tax.