Posted by Mike Smith :: March 7, 2009 @ 5:58 am

Many of us consider our tax bracket as a measure of success and use that number to mentally estimate the amount of taxes that we pay. A much better estimate comes from knowing your effective tax rate, which is rather simple to compute.

Before getting into how to calculate your effective tax rate, let’s review why your rate is not equal to your tax bracket. The simple reason is that the progressive tax rates in the United States apply only the taxable income that falls within each tax bracket. An example using the 2008 tax rates shows how this works. A single filer with $30,000 of taxable income would fall into the 15% bracket. The next lowest bracket, 10%, covers all income up to $8,025. Rather than having to pay 15% on the full $30,000, the taxpayer would pay 10% on the first $8,025 and then 15% on the rest (30,000-8,025=$21,975).

One of the nice features of this system is that you will always take home more pay after getting a raise. If you had to pay the percentage of your tax bracket on all taxable income, then going to a higher tax bracket would dramatically reduce your take-home pay. Earning $8,025 would result in a tax bill of $802.50 (10%), leaving $7,222.50, while earning $8,026 would result in a tax bill of $1,203.90 (15%), leaving only $6,822.10. By charging the bracket rate on only that income which falls into the bracket, this ugly situation is avoided.

Other factors that influence your effective tax rate include state and local taxes as well as any refund received or tax due. To calculate your effective tax rate, add up all of the taxes you’ve paid throughout the year. Be sure to add in any taxes due when you file your taxes for the year or subtract any refund that you receive. Dividing the total tax paid by your taxable income gives you your effective tax rate, which should be lower than your tax bracket.

Your tax bracket number is still important, since it is the percentage of additional income that will be taken out in federal taxes. It should therefore be used when deciding whether or not taking on extra work is worth it. Still, your effective tax rate gives you a better idea of the more pressing question most of us consider: “How much of my income gets taken away through taxes?”

What is your effective tax rate?