Marginal Tax Rate
Understanding how the tax system works can affect the way you think about the money you earn. To fully understand what each dollar of income you receive and each dollar of deduction you have available, you must first understand how to figure your marginal tax rate.
First, calculate your taxable income by adding up income from all sources and subtracting all your allowable deductions. Allowable deductions include adjustments to income (an IRA or Keogh contribution, for example), itemized deductions or the standard deduction and the deductions you claim from personal exemptions.
There are two tax rates that are important for an understanding of how your income is taxed. The "Marginal Tax Rate" is the rate on your last dollar of earnings. For the sake of illustration, use a purely imaginary tax system with two rates. Income up to $10,000 is taxed at 10%. Income in excess of $10,000 is taxed at 20%. If you earned $12,000 in salary, and received a $1,000 bonus, your marginal tax rate on the bonus is 20%, that is, the rate on the last dollar you received. You also use your marginal tax rate to determine the tax benefit of a deduction. If your marginal tax rate is 20%, a $1,000 deduction saves you $200 in income taxes.
The "Effective Tax Rate," on the other hand, is the overall rate at which your income is taxed. Assume the same simple two-rate system and an income of $15,000. The tax on your first $10,000 in income is $1,000 ($10,000 X 10%), and on income of more than $10,000, the tax is $1,000 ($5,000 X 20%). Therefore, your total tax comes to $2,000 ($1,000 plus -$1,000}. Your top "Marginal Tax Rate" is 20%, but your "Effective Tax Rate" is only 13.3% ($2,000 divided by $15,000).
To view current tax brackets, check out our article
2011 Marginal Tax Brackets.
Unfortunately, you must also add in your state income tax rate as well as any local occupational tax. For example, your highest state rate might be 6% and your local tax 2%. For many decisions, you will also include your FICA rate of 6.2% plus the 1.45% for Medicare. The formula would look like this:
(.98 [2% local] X .94 [6% state] X. 72 [28% federal] -.0765 [FICA] = .5867).
In a state with a high income tax, coupled with a high local occupational tax, the marginal rate can approach 50%. The formula for a single person making in excess of $115,000 might look like this: (.97 [3% local] X .91 [9% state] X .64 [36% federal tax] -.0145 [FICA/Medicare] -.034 [FICA on part of earnings] = .5164). This person would keep 51 cents of the last dollar earned! The retention would be even less in a state with taxes up to 18% and the federal maximum rate of 39.6%. Remember, too, that this does not take into consideration sales tax, use taxes, gasoline tax, luxury tax and property taxes.
For a business owner or self-employed person, the tax rate is higher due to state and federal unemployment tax and the double social security.
Application of Your Marginal Tax Rate
Understanding your marginal tax rate helps you appreciate the difference between an expense that is deductible from one that is not. It emphasizes the value of accurate record keeping and wise tax counsel.
