You may consider the amount of money you earn during a calendar year as one lump sum that you call income. But the IRS looks at income in a different way: it charges you different tax rates for different levels of your taxable income. That's because the U.S. income tax is a graduated tax, designed so that people pay an increasing percentage rate as their income rises through various tax brackets as outlined in the table below.
In this tiered system, you pay 15% on the first tier of taxable income (not 10% just yet: see Rate Reduction Credit and What It Means to You below). For a single person in 2001, the first $27,050 in earnings is taxed at 15%. After that, you pay 27.5% on the next tier -- between $27,051 and $65,550 for a single person. You pay increasing percentages as your income rises, topping out at 39.1% on all income over $297,350.
Why is this important? You need to know this because the rate of tax you are paying on your highest dollars of income is called your marginal tax rate, and it can have a tremendous impact on many of your financial decisions. For instance, the cost of selling a short-term stock is higher for someone in the 30.5% bracket than for someone in the 27.5% bracket. Also, the higher your tax bracket, the more appealing investments like tax-free municipal bonds become.
The marginal tax rate shows you just how valuable reducing your taxable income can be to your financial health. Following is a listing of the marginal rates effective for 2001:
| Your tax rate is: |
Single |
Married filing joint or qualifying widow(er) |
Head of household |
Married filing separately |
| 15% if your taxable income is over: |
$0 |
$0 |
$0 |
$0 |
| 27.5% if your taxable income is over: |
$27,050 |
$45,200 |
$36,250 |
$22,600 |
| 30.5% if your taxable income is over: |
$65,550 |
$109,250 |
$93,650 |
$54,625 |
| 35.5% if your taxable income is over: |
$136,750 |
$166,500 |
$151,650 |
$83,250 |
| 39.1% if your taxable income is over: |
$297,350 |
$297,350 |
$297,350 |
$148,675
|
The Rate Reduction Credit and What It Means to You
Starting in 2001, a new 10% regular income tax bracket exists for a portion of taxable income that was previously taxed at 15%. This new 10% tax bracket applies to the first $6,000 if you're filing as single or you're married and filing separate income tax returns, $12,000 if you're married and filing a joint return or if you're a qualifying widow(er), or $10,000 if you're filing as head of household.
However, for 2001 only, there is a rate reduction credit to deliver the benefit of the new 10% income tax bracket. This credit entitles you to a reduction of your taxes equal to 5% (the difference between the 15% rate and the 10% rate) of your income that would otherwise be eligible for the new 10% rate. For example, if your filing status is single, the maximum amount of your rate reduction credit would be $300 ($6,000 times 5%).
Most likely you received an advanced payment in the mail in 2001 for the amount of the rate reduction credit you were eligible for based on your 2000 tax return. However, if you received a letter from the IRS stating that you weren't eligible for an advanced payment of this credit because you didn't have an income tax liability on your 2000 return, you are still entitled to this credit on your 2001 tax return (so long as you have an income tax liability) up to the maximum amount for your filing status.
Future Marginal Tax Rates
With the signing of the new tax laws on June 7th, things changed somewhat for 2001. The new 10% tax bracket becomes effective through a rate reduction credit as described above. The next bracket of income will still be taxed at 15%. However, effective July 1, 2001, the previous regular income tax rates of 28%, 31%, 36% and 39.6% are phased down over six years to 25%, 28%, 33% and 35% respectively. Here's a glimpse of what's to come in the future:
| Calendar Year |
28% Rate Reduced to: |
31% Rate Reduced to: |
36% Rate Reduced to: |
39.6% Rate Reduced to: |
| 2001 |
27.5% |
30.5% |
35.5% |
39.1% |
| 2002 |
27% |
30% |
35% |
38.6% |
| 2003 |
27% |
30% |
35% |
38.6% |
| 2004 |
26% |
29% |
34% |
37.6% |
| 2005 |
26% |
29% |
34% |
37.6% |
| 2006 and later |
25% |
28% |
33% |
35% |
|
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