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What Is a Marginal Tax Rate?

Taxes are part of our everyday life. Right off the bat a portion of your earnings is allocated to taxes. Moreover, to understand how much you owe toward federal income tax, you will need to understand marginal tax rate.

This rate is a percentage of tax that you incur on any given dollar of income. Additionally, it is not a flat rate tax that charges everyone the same amount regardless of their income. Instead, with marginalized tax rates, the higher your income, the greater of a percentage of tax you pay. It is all specified within seven different income tax brackets. In short, the reason for this is that the federal government seeks to have a higher tax burden for households with greater income, which protects low-income taxpayers.

How Does Marginal Tax Rate Work?

Currently the federal income tax system has tax brackets that includes seven tax rates for individual income. Depending upon your income, you will fall into one of these tax rate categories: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The higher your income, or your household income, the higher your marginal tax rate will be.

Below, you will find details for the 2021 federal income tax brackets for the various types of filing statuses. More importantly, you should note that the tax brackets apply to taxable income, including more than just wages. In short, meaning interest or dividends from investments, wages, bonuses, unemployment benefits, and cancelled debts will all be included as part of your taxable income. However, this excludes deductions and adjustments that you are eligible for.

RateSingle IndividualsJoint ReturnsHead of Household
10%Up to $9,950Up to $19,900Up to $14,200
12%$9951 to $40,525$19,901 to $81,050$14,201 to $54,200
22%$40,526 to $86,375$81,051 to $172,750$54,201 to $86,350
24%$86,376 to $164,925$172,751 to $329,850$86,351 to $164,900
32%$164,926 to $209,425$329,851 to $418,850$164,901 to $209,400
35%$209,426 to $523,600$418,851 to $628,300$209,401 to $523,600
37%$523,601 or more$628,301 or more$523,601 or more

What Does Marginal Tax Rate Mean?

The United States tax system is a progressive system that utilizes marginal tax brackets. As shown above, they are used to calculate the income ranges that correspond to the percentage of tax individuals or couples owe. As you can see in the above graph, the higher your income, the higher your tax bracket becomes.

One common misconception is that your entire income is taxed based on your marginal tax rate. Luckily, that is not the case. However, the more money you earn, the more tax brackets you fall within.

For example, if you are a single individual that earns $100,000 per year your entire income will not be taxed at the 24% rate. Instead, you will owe 10% of the first $9,950 of income, 12% for your income between $9,951 and $40,525, 22% for your income between $40,526 and $86,375. Lastly, with the 24% of the remaining portion of income between $86,376 and $100,000.

Why Are Marginal Tax Rates Important?

Understanding your marginal tax rate is important because it will give you insight into the tax consequences of adding additional earnings. This is especially important to investors.

Imagine if you were considering investing in a rental property that would provide $30,000 of additional income per year, but it would push you into a higher tax bracket. Having this information is a valuable tool to determine the best course of action for your investments and the tax (or deductions) that it may incur.

How Do Tax Brackets Affect Marginal Tax Rate?

Since the United States Government uses a marginal tax rate, as a taxpayer it is your obligation to determine which tax bracket you fall into. As mentioned above, your taxable earnings will be taxed at a higher rate as your income increases.

How Can Marginal Tax Rates Affect My Taxes?

Understanding how your taxable income, from wages or investments, are calculated, along with understanding deductions can reduce your taxable income. Claiming credits and deductions can lower your marginal tax rate, thus reducing the amount of taxable income you are required to pay taxes on.

What Is an Example of a Marginal Tax Rate?

Many companies provide their employees with annual increases. If you currently have an income of $162,000 per year, you have a marginal rate of 24%.

However, if your company offers you a raise of $5,000, almost half of the additional income will be taxed under the 32% rate. After taking the raise, you might choose to itemize deductions or donate enough money to charity to keep your marginal tax rate within the 24% tax bracket.

What Is the Marginal Tax Rate Formula?

To calculate your marginal tax rate, first you need to determine how much income you are currently making. Once you have calculated your taxable income, you will then calculate each tax bracket until you have reached your total income.

For example, if you earn $100,000 per year you will calculate your income as follows:

  • 10% of the first $9,950 of income = ($9,950 – $0) x 10% = $995.50
  • 12% for your income between $9,951 and $40,525 = ($40,525 – $9,950) x 12% = $3,669.00
  • 22% for your income between $40,526 and $86,375 = ($86,375 – $40,525) x 22% = $10,087.00
  • 24% for the remaining portion of income between $86,376 and $100,000 = ($100,000 – $86,375) x 24% = $3,270.00
  • 32% Bracket: Not applicable
  • 35% Bracket: Not applicable
  • 37% Bracket: Not applicable

Keep calculating each bracket until you have calculated your entire taxable income. As you can see in this example, there was no tax calculated under the 32%, 35%, and 37% brackets. Additionally, only a portion of the 24% bracket was calculated based on the total income of $100,000.

How To Find Marginal Tax Rate

To find your marginal tax rate, gather all your taxable income sources and calculate the total. You can then utilize the table above to find out which tax rates you fall under.

Marginal Tax Rate vs. Effective Tax Rate

As we found out above, your marginalized tax rate is calculated from tax brackets. Each level of income is taxed at a different percentage. Your effective tax rate is what is the overall percentage of what you owe to the IRS.

In our example, we found that If you earned $100,000 annually you would pay the following:

  • 10% = $995.50
  • 12% = $3,669.00
  • 22% = $10,087.00
  • 24% = $3,270.00

Total owed in taxes = $18,021.50

To calculate your effective tax rate, you take the $18,021.50 you would owe for tax and divide it by your annual income of $100,000. You will find your effective tax rate is slightly above 18%.

18,021.50/100,000 = 0.180215 = 18.0215%

So, while your marginal tax rate may be 24%, your effective tax rate is much lower.

Marginal Tax Rate vs. Flat Tax Rate

With marginal tax rate, the more you earn the higher of a percentage you pay. Alternatively, a flat tax is how it sounds, everyone would pay the same tax rate regardless of income.

Other countries utilize flat tax rates, where the rate does not fluctuate based on income. This type of taxing rate also only taxes income. However, dividends, capital gains, distributions, and other income sources are typically exempt from flat tax rate models.

Tax Rates Do Not Have to Be Complicated

There is good news, the IRS lays out all the information that is pertinent to taxpayers in the United States on their website for easy access. The even better news is there are professionals, like financial advisors, who can help guide you on important tax decisions.

Before making investments that could impact your tax obligations, reach out to your financial advisor to ensure that you are making the right investment moves and deductions.