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Marginal vs. effective tax rates

By Kay Bell · Bankrate.com
Tuesday, January 24, 2012
Posted: 1 pm ET

We now all know what the Internal Revenue Service knows about Mitt Romney. He's rich -- earnings of $21.7 million in 2010 and an estimated $20.9 million last year -- and he pays a relatively low tax rate because most of his earnings in 2010 and 2011 were from investments.

Most of Romney's money, known as unearned income versus the earned income most of us get from wages, is taxed as capital gains. And the top capital gains tax rate (for now) on long-term investments is just 15 percent.

President Obama is expected to discuss this apparent tax disparity in his State of the Union address tonight.

And as I asked last week, the issue of whether the capital gains tax rate is at an appropriate level will continue to be a matter of contention throughout the 2012 presidential campaign.

Congress also will get in on the debate, especially toward the end of the year as the expiration date of the capital gains tax rates and the other Bush-era tax cuts nears.

All of this talk, be it heated candidate forums or you and I mulling the issue, is good.

Pay attention to progressive taxation: I had one such productive exchange last week with blog reader Kevin, who pointed out that when we talk about tax rates, we've got to take into account the way they are calculated.

Kevin took issue with my example of a person in the 25 percent income tax bracket. He correctly noted that just because your earnings happen to fall into a certain tax bracket, that's not necessarily the rate of tax you'll pay on your income.

Most of us likely pay a lower overall rate of tax than what our tax bracket indicates. The reason is because our tax system is progressive.

We now have six income tax rates, starting at 10 percent and topping out at 35 percent. And all the ordinary earnings, that is, our wages, are taxed at all those rates.

Take, for example, a single taxpayer making $175,000. That total puts that filer in the 33 percent tax bracket, but he doesn't pay 33 percent on the whole $175,000.

He pays 10 percent, 15 percent, 25 percent, 28 percent and 33 percent on that money based on the amounts that are covered by the tax brackets.

The bottom line is that this hypothetical taxpayer doesn't owe the IRS $57,750, which is 33 percent of $175,000.

Rather, he owes Uncle Sam $42,622, which is an effective tax rate of around 24 percent. This is because parts of his earnings are also taxed at rates lower than his top, marginal tax rate of 33 percent.

You can see the precise tax bill breakout for our hypothetical $175,000 earning taxpayer in Bankrate's Tax Basics article What's my tax rate?

The bottom line is that you can't just rely on your marginal tax rate, which is the tax bracket rate applied to the last dollar you earn. Rather, you need to look at your effective tax rate, which is calculated by dividing the tax you owe by your taxable income amount.

And I want to make it clear this time for Kevin and other tax-savvy blog readers: This also is just an example for illustrative purposes only. But you get the idea.

So if after figuring your effective tax rate you find you are paying more than Romney, you can still grumble. But just make sure you're using the correct tax rate for comparison.

Keep up with tax rate debate and other tax news by subscribing to Bankrate's free tax newsletters. You can sign up to get a Daily Tax Tip. Or if you prefer a more consolidated collection, subscribe to the Weekly Tax Tip newsletter. Or sign up for both.

You also can follow me on Twitter @taxtweet.

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