What Are "Tax Brackets"?
Ooh, this is a good one, because it's the source of a lot of confusion. The U.S. income tax code is called progressive, because the tax rates increase as income increases. In 2013, for example, income up to $8,925 was taxed at 10 percent. Income between $8,926 and $36,250 was taxed at 15 percent. And income between $36,251 and $87,850 was taxed at 25 percent. Someone who earned $50,000 is said to be in the "25 percent tax bracket." Seems easy enough, right?
When we say someone is in the "25 percent tax bracket," it sounds like all 50,000 of their dollars are taxed at 25 percent, which would be $12,500 in taxes. But that's not true. Only the money greater than $36,250 is taxed at 25 percent. The rest is taxed at 15 percent and 10 percent according to the dollar amounts we just listed [source: Fidelity]. The real tax owed by a single filer on $50,000 is $8,428.75. That's a tax rate of 16.8 percent. (The real rate would be considerably lower after deductions and exemptions.)
"Tax bracket" is a meaningless term. The correct word is marginal tax rate. That's the tax rate charged to the last dollar you earn in a tax year — 25 percent in our example above. The real rate that you pay the IRS — 16.8 percent in our example — is called the average or effective tax rate. The average rate is always lower than the marginal rate, unless you make $8,925 or less, in which case they are equal.