What’s Your Income, What’s Your Tax Rate, and Why Should You Know?

There’s no flat tax for individual taxpayers. Because of graduated income tax brackets, phase-outs of certain write-offs, and additional taxes that can apply, determining your tax rate isn’t easy. Tax terms can be confusing but are important to master.

Understand the terminology

A number of different tax terms may be bantered about, but they don’t all mean the same thing. Here is a glossary of tax terms that may be helpful to understand the meaning of “income” and “tax rate”:

Income terms:

• Alternative minimum taxable income (AMTI). This is the amount on which the alternative minimum tax (AMT) is figured. (This tax applies if it is more than your regular tax.) AMTI is adjusted gross income (explained below) increased by tax preference items and increased or decreased by various adjustments specifically for AMT purposes.
• Adjusted gross income (AGI). This is gross income reduced by allowable deductions, such as IRA contributions and alimony payments. Adjusted gross income is used to determine not only modified adjusted gross income (explained below), but also various limitations, including the threshold for deducting medical expenses and miscellaneous itemized deductions and the phase-outs in personal exemptions and itemized deductions.
• Household income. This is a new term in tax law that debuted as a result of the Affordable Care Act. It is modified adjusted gross income (explained below) increased by any excluded foreign income and tax-exempt interest and covers the total amount from the taxpayer and any dependents required to file tax returns. The term is used for determining eligibility for the premium tax credit and for imposing a penalty on anyone who fails to carry minimum essential health coverage.
• Modified adjusted gross income (MAGI). This is AGI increased by certain items, such as the foreign earned income exclusion. The term is used for limits on certain exclusions (e.g., interest on U.S. savings bonds for education), deductions (e.g., IRA contributions), and tax credits (e.g., retirement savers credit). MAGI can have different meanings depending upon the context in which it is used (i.e., different add-ons apply for different tax purposes).
• Taxable income. This is the amount on which the regular tax is figured. It is AGI reduced by personal exemptions and either the standard deduction or itemized deductions.

Tax rate terms:

• Effective tax rate. This is your net tax rate, which is the percentage of your taxable income that is used for income taxes. It takes into account the phase-outs of itemized deductions and personal exemptions, and other taxes you pay. It also includes additional Medicare taxes. If you do not have these phase-outs or other taxes, your effective tax rate will be lower than your marginal tax rate (explained below).
• Marginal tax rate. This is your top tax bracket (see below). For example, if your marginal rate is 25%, then additional income is taxed at that rate. However, too much additional income pushes you into the next tax bracket, which is a higher marginal rate of 28%.
• Tax bracket. There are seven tax brackets: 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. When describing the tax bracket you are in, it refers to the top one that may apply to you. This obviously takes into account the fact that you are also in every bracket below your top rate.
• Tax liability. This is the dollar amount of taxes you pay. It takes into account not only regular tax, but also any additional taxes and tax penalties.

Why you should know the terminology

Understanding these unique tax terms can help you strategize for tax purposes. For example, if you are in the 10% or 15% tax bracket, you pay no tax on long-term capital gains and qualified dividends. However, if you take in additional capital gains and qualified income, or any other income, this can throw you into the 25% tax bracket, voiding the zero tax rate. For 2014, the 15% tax bracket runs to $73, 800 for joint filers and surviving spouses, $49,400 for heads of households, and $36,900 for singles and married persons filing separately.

It is important to recognize that going from, say, the 25% bracket to the 28% bracket does not mean your overall tax jumps significantly. By definition, the brackets are graduated. Being in a higher tax bracket does not change the fact that your income up to that higher bracket continues to be taxed in the lower brackets.

Conclusion

The better you understand tax terms and how they apply to you, the savvier tax decisions you can make.