What Are Tax Brackets?
The concept of a “Tax Bracket” or “Tax Rate” can be very confusing. After finishing a stretch of overtime or receiving a bonus, the additional taxes are often considered the result of a “higher tax bracket”. There is some truth to this assumption.
Our Federal tax system is progressive. A progressive tax system is based on layers of tax rates that kick in as additional income is earned. To illustrate, a progressive tax system may tax the first 10K of income at 10%, then next 10K of income at 20% and the next 30K of income at 30% and so on. Each additional dollar earned is taxed at the same rate until the cumulative income reaches the next stage. At that point, each additional dollar is taxed at the higher rate. For example, using this same schematic, if I earn $10,000 for the year, my tax will be $1000 or 10% of the total. The next dollar I earn is taxed at 20% so my total tax is $1000 + .20c since the next $10,000 are taxed at 20%. When paychecks are issued, the tax withholding is calculated as if the earning on that check reflects our rate of earnings through the entire year. The amount withheld is the result of a calculation that considers the total income for the year based on your earnings during the payroll period and the eventual tax of that income base as it works through the tax brackets.
Often, a tax professional will talk about an “effective” tax rate. An effective tax rate is the actual percentage of tax applied to a given income. Using the same schematic above, if I make $15,000, my tax will be $1,000 on the first $10,000 and then $1,000 on the next $5000. Thus my effective tax rate is 13.3% or 2,000 divided by 15,000. When I reach $20,000 income, my effective tax rate is 15% or 3,000 divided by 20,000. Even though I was still in the 20% tax bracket, my actual rate for total income is 15%.
Almost every state has a series of tax brackets as well. Only a handful have a flat tax. Tax brackets are required to be adjusted for inflation so one is not penalized for making additional income to meet the same standard of living. Despite the adjustment for inflation, those that live in high cost areas are penalized by our tax system. A nurse working in a large east or west coast city will often make much more than a nurse working in the rural Midwest. Even though there is a large disparity in income, the nurse on the Midwest will most likely have more buying power as the cost of living is lower and the taxes that they pay make up less of their total expenses. When one lives in an area with a higher cost of living, a higher wage is required - but with higher earnings, comes higher taxes. Some congressmen want to adjust tax rates based on cost of living indexes for this reason alone. A person that makes $250K may be rich to many people, but if that individual lives in a large city or area with a high cost of living, their spending power will be much less than the person making the same money in the country with lower living expenses. For this reason alone, the definition of “rich” is often a relative term.
A good resource for tax rates can be found at http://www.moneychimp.com/features/tax_brackets.htm
About the author:
Joseph Smith is an IRS Enrolled Agent and former travel respiratory therapist whose firm (TravelTax LLC) provides tax preparation and audit representation for the mobile professional. He is a regular contributor to HealthcareTraveler, Locum Life and a speaker at the annual Travel Medical Professionals Convention. For more travel nursing tax advice, visit TravelTax.com.
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