How Tax Brackets Work

The U.S. federal income tax system is so complicated, it even confused Albert Einstein-he once called the income tax "the hardest thing in the world to understand."

Our federal income taxes are assessed on a marginal tax scale, which basically means that higher levels of income are taxed at progressively higher rates. And what are tax brackets, you ask? Tax brackets are the defined income levels to which the various tax rates are applied.

Knowing how tax brackets work helps you plan your tax liability on every extra dollar you earn. Say you work full-time, and you are considering starting up a small business on the side. Budgeting for your tax expenses is a planning step you'll need to take; it's as important as budgeting for your cost of good sold, shipping costs and other routine business expenses. You can also use tax brackets to estimate the savings you might realize by increasing your tax deductions.

Inflation's good side

It's important to note here that tax brackets can change every year. By law, parts of the tax code have to be adjusted annually in accordance with inflation trends. When inflation rises, the tax bracket thresholds widen, allowing more of your income to fall into the lower brackets. This is the IRS' way of protecting your wealth and lifestyle when the cost of the living in the U.S. is on the rise. The 2009 tax brackets, therefore, aren't the same as the 2008 tax brackets, and they may not be the same as the 2010 tax brackets either.

Levels and status

Separate tax brackets are defined for the various tax filing statuses: Single filers have their own brackets, as do heads of households and those who are married but file separately. Married, joint filers have the same tax brackets as qualifying widowers. There is also a bracket structure for long-term capital gains and dividend income.

With the exception of long-term capital gains and dividends, the tax rates range from 10 percent for the lowest bracket up to 35 percent for the highest bracket. Note that being in the top tax bracket doesn't mean you'll pay out 35 percent of every dollar you earn. You are only charged 35 percent against the income that falls into that bracket's range; lower levels of income are charged at the lower rates, as defined by the lower tax brackets.

Here's an example to clarify: the bottom two brackets for single filers are 10 percent on taxable income between $0 and $8350 and 15 percent on taxable income between $8350 and $33,950. If you make $25,000 in taxable income, you'll be taxed 10 percent on the first $8350 and 15 percent on the remaining $16,650. Your total will be $3332.50, which is 13.3 percent of your taxable income.

Long-term capital gains and dividends are either taxed at 0 percent or 15 percent, depending on your income level.

Where to find more information

The instructions for IRS Form 1040 contain two tools to help you clarify your tax bracket:

• A tax table that shows tax liabilities for taxable income levels up to $100,000
• A tax computation worksheet showing how to apply tax rates to taxable income levels in excess of $100,000

These instructions are accessible for download on the IRS website. Also, look for the IRS to announce the next year's brackets in October.