Income Tax Rates

Marginal Tax Brackets and Income Tax Rates

The United States imposes tax on income using progressive rates. That means that a person's tax liabilities gradually increases as income increases. There are currently six tax brackets, ranging from ten percent to thirty five percent. These six tax brackets are scheduled to expire, along with other tax reforms signed into law under President G.W. Bush, at the end of the year 2010. President Obama has signaled his desire to increase the top two tax brackets, effectively increasing the tax burden on higher income persons.

Terminology

We speak of marginal tax brackets to refer to the tax imposed on the next dollar earned. This is a useful concept for tax planning, as it enables people to analyze the tax impact of additional income or additional deductions. The marginal tax bracket is the highest tax rate imposed on your income.

These marginal tax rates are also called ordinary income tax rates. That's because these tax rates apply to most kinds of income, and are distinguished from the more favorable capital gains tax rate imposed on long-term gains and qualified dividends.

The Marginal Tax Brackets

There are six marginal tax brackets:

• 10%
• 15%
• 25%
• 28%
• 33%
• 35%

These rates are imposed by Congress and found in section 1 of the Internal Revenue Code. The income to which these rates apply adjusts every year. The IRS updates the official tax rates to take into account inflation.

The Hidden Zero Percent Tax Bracket

Everyone is entitled to a standard deduction or itemized deductions and one or more personal exemptions. Together these constitute a zero percent tax bracket, in the sense that there's no tax imposed the income represented by these deductible expenses.

Progressive Structure of the Tax Rates

The ordinary income tax rates are called progressive because the tax rate that applies gradually increases as a person's income increases. A person with $1 million in income, just to take an example, would have their income taxed at all the tax brackets. Progressive tax rates are distinguished from a flat tax (in which there's one tax rate that applies to all income) or a regressive tax rates (in which tax falls heaviest on lower-income persons).

Average Tax Rates versus Marginal Tax Rates

Marginal tax rates only tell half the story when it comes to tax planning. Also important is a person's average tax rate. This rate is a person's total federal tax liability divided by his or her total income. Average tax rates indicate, on average, what the federal government taxes on a person's income. To take one example using 2009 tax rates, an unmarried person with $50,000 in taxable income subject entirely to ordinary tax rates might have a tax liability of about $8,688, putting this person in the 25% tax bracket but having only 17% average tax rate. To find your own average tax rate, take your total federal tax liability and divide by your total income.

Obama's Proposals for Changing the Marginal Tax Brackets

Currently there are six tax brackets: 10%, 15%, 25%, 28%, 33%, and 35%. Those tax brackets were implemented in 2001 and are scheduled to expire at the end of 2010. If Congress does not pass a new law, the marginal tax brackets will revert to their pre-2001 levels, which were five tax rates of 15%, 28%, 31%, 36%, and 39.6%.

Instead of reverting to these tax rates, President Obama has proposed to continue using six tax rates: the 10% through 28% tax rates would remain the same and the top two rates would of 33% and 35% would be replaced with 36% and 39.6% rates, respectively. How income is measured in determining the tax bracket would also change. The 36% bracket would begin at $200,000 minus the standard deduction and one personal exemption for single filers, and at $250,000 minus the standard deduction and two personal exemptions for married filers. How tax rates are determined remains unchanged for the other tax brackets. The beginning of the 39.6% bracket was not explained in the administration's Greenbook. The new tax rates would begin in 2011, but requires Congressional action to implement these legislative proposals.