Unless you make your living by helping people complete their returns, you probably prefer to spend as little time as possible thinking about income taxes. The rules and forms are generally opaque and the process is often stressful. However, there is at least one concept in the U.S. tax system that is both very simple and really important, and yet I find that it is unfamiliar to many. That concept is the Marginal Tax Rate, and the short version goes like this:
Your marginal tax rate is the rate at which your next dollar of income will be taxed.
Now let’s see just how that works and why it matters to you.
If the U.S. had a so-called “flat tax,” then each person would pay a fixed percentage of his or her income. For the sake of example (and putting all political agendas aside), let’s say the flat rate were 10%:
$10,000 income x 10% = $1,000 tax
$1,000,000 income x 10% = $100,000 tax
Simple enough, and the person with the higher income would pay a proportionally higher tax.
However, the U.S. has instead what is called a “progressive” tax system. It’s like a layer cake. The bottom layer is taxed at a certain rate; the next layer is taxed at a higher rate; the next at a still higher rate. We call these layers “tax brackets.” Here is what the brackets for a married couple filing jointly looked like in 2015:
The logic here is that the higher your income, the higher the rate at which that income will be taxed. The tax rate becomes progressively higher as income increases, hence the name.
What Is Marginal Tax Rate?
Your marginal tax rate is simply the rate at which your next dollar of income will be taxed. Let’s say that our married-filing-jointly couple, Jack and Jill, had income only from their jobs in 2015. After deductions, they had a taxable income of $74,900. They are at the top of what we would call the “15% tax bracket.”
Then Jill received a one-time year-end bonus of $1,000, raising their total family income to $75,900. How much of that bonus will be lost to federal tax? Recall our table:
Every dollar earned starting with dollar # 74,901 (and continuing until 151,200) is going to be taxed at 25%. So she will pay $250 of that bonus in federal tax.
$1,000 x 25% = $250
What Marginal Tax Rate Isn’t
If someone were to ask our couple what tax bracket they were in, they would say, correctly, “25%.” Many people assume, incorrectly, that this would mean they are paying 25% of their total income in taxes. But that is not the case. This couple is paying 10% of their first $18,450 of income, 15% of the next $56,450, and 25% of the last $1,000.
And so, they are actually paying an effective rate that is just a bit less than 14%.
$75,900 income / $10,562.50 tax = 13.92% effective tax rate
Why Does It Matter to You?
Now that you understand how it works, you ask the obvious existential questions: So what? Why do I care?
Knowing your marginal tax rate is essential to anticipating the tax consequences of new income or new deductions. Consider some examples:
Our couple knows that their effective tax rate is currently around 14% but their marginal rate is 25%. What if they decide to acquire a profitable new investment property? They need to recognize that the additional income, which is layered on top of their employment income, is going to be taxed at their marginal rate of 25%. That information may factor into their decision as to whether the income from that property, after-taxes, is attractive enough to justify the cost and the effort.
What if they were thinking about making a $1,000 donation to charity at the end of 2015, or possibly waiting until next year to do so? If Jill’s bonus is indeed a one-time event, she would save $250 on their joint taxes if she makes that donation this year, while she is in the 25% bracket; but she would save only $150 if she waits until next year when she expects to drop back under the 25% marginal rate and into the 15% bracket.
Perhaps in 2016 this couple encounters a fantastic real estate opportunity where they make a quick $85,000 profit. Short-term gains are treated as ordinary income, so add this profit to the $74,900 taxable income they had expected from their jobs and you can see that they will catapult across two tax brackets. At $159,900, assuming the bracket table remains the same, their marginal rate is going to jump to 28%.
By being aware of their new marginal rate and where it is that they may fall within that 28% tax bracket, they can do some sensible tax planning. It looks like $8,700 of their income (i.e., the amount that their 2016 income is over $151,200), will be taxed at 28%. Are there some 2017 deductions that they could accelerate into 2016? Perhaps they could pre-pay the property taxes on their home. All or part of that deduction would save 28% if they took it the year of atypically high income, versus 15% in a year where their income returned to the 15% bracket.
One word of caution to so-called high-income investors (and that could mean folks with income as low as about $200,000 for individuals or $250,000 for joint filers): There are a variety of potential gotchas lurking for you in the ever-changing tax code. Certain deductions or exemptions may phase out, and the Net Investment Income Tax may kick in. Don’t try parsing this at home; consult a professional tax advisor.
For most people, however, awareness of your marginal tax rate and where you fall in the tax-bracket chart can be a big help in understanding the consequences of changes in income and making informed tax-planning decisions.
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