What it is:
How it works/Example:
The United States has a progressive tax system, which means that different portions of a person's income are taxed at different rates (the rates are often referred to as "marginal tax rates").
For example, the IRS might tax a single filer's $100,000 income as follows:
The first $8,025 is taxed at 10% = $802.50
The next $24,525 is taxed at 15% = $3,678.75
The next $49,100 is taxed at 25% = $12,275.00
The final $18,350 is taxed at 28% = $5,138
Total tax owed: $21,894.25
Because this filer's highest taxable rate is 28%, we say that he or she is in the 28% tax bracket. Note, however, that not ALL of the taxpayer's income is taxed at 28%. In fact, the taxpayer's effective tax rate is $21,894.25 / $100,000 = 21.9%.
The highest tax brackets often change, but they are usually around 35%. Note that income tax rates exclude state taxes and social security/Medicare, which add as much as another 17%-18% in taxes.
Why it matters:
It's important to know the difference between tax brackets and tax rates. Many people assume that when they're in the 28% tax bracket, for example, that all of their income is taxed at 28%, which is not the case. As our example shows, you can be in the 28% tax bracket but have a much lower effective tax rate on your income.