Feb 4th, 2008
Working Backwards: What’s a Tax Bracket?
A tax bracket is simply the rate at which someone is taxed. Typically, in the United States, the term “tax bracket” refers to Federal income tax brackets, although states with income tax systems also typically use tax brackets. The brackets themselves are associated with the tax payer’s income.
For 2007, Federal tax brackets for single people are:
* 10%: from $0 to $7,825
* 15%: from $7,826 to $31,850
* 25%: from $31,851 to $77,100
* 28%: from $77,101 to $160,850
* 33%: from $160,851 to $349,700
* 35%: $349,701 and above
To explain what this means, let’s use an example. Pretend I, a single person, have gross earned income on a W2 form in 2007 of $50,000 and no other income nor deductions of any type. If I use the standard deduction of $5,350 and personal exemption of $3,400, that brings my taxable income to $41,250, which puts me squarely in the 25% bracket. This means:
The first $7,825 of taxable income I earn is taxed at 10%; the next dollar after that up to $31,850 is taxed at 15%; and the final amount from $31,851 to $41,250 is taxed at 25%, all at the Federal level. This theoretical example has the tax calculated at $6,735.10; in reality, someone using the tax tables in the 2007 1040 instructions would calculate a Federal tax of $6,743 (the tables are in $50 increments, which results in a type of “rounding” which isn’t all that round).
Any other taxable money I earn above and beyond that $41,250 would be taxed at the Federal level, with some exceptions (long term capital gains and qualified dividends being two that come to mind), up to the next bracket which starts at $77,101. So if I earned $100 in interest income from a money market account in 2007, $25 of that would be the property of Uncle Sam. This is an example where understanding tax brackets can be quite useful: if I’m earning that $100 of interest as a result of $4000 in an account at 2.5% interest (to make the math easy, we are not compounding interest!), I may want to see if I can find a tax exempt money market fund which pays more than 1.875% interest (1.875% being equal to 2.5% minus 0.625%, that is the effective post tax rate of interest being equal to the rate of interest paid minus the amount being paid in Federal taxes). Of course, this is a very simplified example; money market rates do change occasionally (and tax brackets do as well, less often), and we are not taking into account the effect of compounding. Still, understanding tax brackets can be useful in many situations to judge if a certain type of financial arrangement is worthwhile.
