You've heard it before, chatting at a cocktail party or even just in casual conversation with a business associate: What's your tax bracket?

What... that hasn't happened to you? You need to party with more accountants (lots of drinking games involving calculators). But before you do, make sure you know the truth about tax brackets, one of the most misunderstood aspects of taxes.

When people speak about their tax bracket or tax rate, they're generally referring to their "marginal" tax rate. Your marginal tax rate is the rate at which your last dollar of taxable income is taxed, not the rate at which all your dollars are taxed. It's the maximum rate you're paying on any of your dollars of taxable income. For 2001, marginal tax rates will be 10%, 15%, 27.5%, 30.5%, 35.5%, and 39.1 %.

Your marginal tax rate only deals with the specific tax on your income. There are other taxes you may have to pay -- such as self-employment taxes, alternative minimum tax, and even penalty taxes on retirement plan distributions. There are also credits you may benefit from, such as the child tax credit, the dependent care credit, or the education credits. After this jumble of other taxes and credits, your marginal tax rate may lose a bit of its importance. That's why you'll want to take a peek at your effective tax rate.

To find out the average rate of taxation for all your dollars, you need to compute your effective tax rate. This is simply your total tax obligation (including your income tax and any other additional taxes and/or credits) divided by your total taxable income. It's very possible that your effective tax rate could be much higher than your marginal rate. Why? Because you may be self-employed and get hit with the self-employment tax as an addition to your normal income tax.

An example
Mary is a single person. In 2001, if she has taxable income of $27,050 or less, her marginal tax rate will be 15%. But if her taxable income climbs to between $27,051 and $65,550, her marginal tax rate will be 27.5%. So if Mary has taxable income of $30,000, the first $27,050 of her taxable income would be taxed at 15% (resulting in a tax liability of $4,057.50), and the remaining $2,950 would be taxed at 27.5% (yielding an additional liability of $811.25). Add those sums together and you get Mary's total tax liability: $4,868.75. But don't forget that Mary most likely received her $300 tax refund early in 2001. So her actual tax amount for 2001 is $4,568.75.

When looking at the "big picture," you should compute your "effective" tax rate. This is simply your total tax liability divided by your taxable income. In the example above, while Mary's marginal tax bracket is 27.5%, her effective tax bracket is only 15.23% ($4,568.75 divided by $30,000 equals 0.1523). The effective rate tells Mary that most of her income is being taxed at the lower 10% and 15% brackets, and only a small portion is being taxed at the next (27.5%) bracket.

So, to summarize Mary's tax situation:

• Mary's marginal tax rate: 27.5%.
• Mary's effective tax rate: 15.23%.
• Most of her dollars were taxed at the lower 10% and 15% tax rates.
• Her next dollars will be taxed at 27.5%.

How to find yours
Determining YOUR marginal and effective tax brackets is not too difficult. If you're looking for your marginal bracket, simply turn to your 2000 tax return. Find the number located on line 39 if you filed Form 1040, or line 25 if you filed Form 1040A, or line 6 if you filed Form 1040EZ.

Then take that number and see where it falls in the 2000 tax tables. Don't forget to make sure to read the correct table based upon your filing status. In other words, don't use the married tables to find your marginal tax bracket when you're actually a single person. That will give you your marginal tax bracket, and will tell you at what rate your next dollar of income will be taxed. And it'll also allow you to see how close you might be to your next bracket.

If you're looking for your effective tax rate, it's almost as simple. Grab your 2000 tax return and make the following computations:

• If you filed Form 1040, divide the amount on line 57 by the amount on line 33.
• If you filed Form 1040A, divide the amount on line 35 by the amount on line 19.
• If you filed Form 1040EZ, divide the amount on line 10 by the amount on line 4.

Once you do that division, you'll arrive at your effective tax rate. And that will give you a good idea of where most of your income is being taxed.

Remember that you are using historical data (your 2000 tax return) to arrive at your marginal and effective brackets. If your income, deductions, and credits will remain similar in 2001, it's likely that your brackets will also remain similar. But if you expect a large increase or decrease in your income for 2001, you might want to check out your 2001 bracket by using the information that you have at your disposal along with the 2001 tax tables.

Why you should care
If you are on the cusp of the next tax bracket, you want to defer income or find more deductions. Have you contributed as much as you can to your 401(k)? Given to charity? For more strategies, check out our series on year-end tax planning tips.

Everybody should know how to arrive at his or her tax bracket, and use it to its maximum advantage. It's an important number, and a number that you'll need to know before you make any tax-based decisions. So make sure that you know yours.

Related Links:
2000 Tax Rate Schedule
2001 Tax Rate Schedule
Year-End Tax Planning Tips
20 Foolish Tax Tips
Save by Planning Your Taxes Now
New Rate Cuts and Rebates

If you like the way Roy Lewis simplifies confusing tax issues, check out his just-published book, The Motley Fool's Investment Tax Guide 2000: Smart Tax Strategies for Investors. This handy 360+ page guide covers just about every tax aspect of a typical Fool's life: investing, marriage, children, education, homes, home offices, retirement accounts, medical expenses, and much more.)

September 28, 2001

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