What is Marginal Tax Rate?
Your marginal tax rate is the percentage you pay in taxes on the part of your income that falls within the highest tax bracket you qualify for.
The United States uses a progressive income tax system, meaning that the more money you make, the more you’re supposed to pay in federal income taxes. Your income falls into one of seven tax brackets, each with a higher rate. A common misconception is that you pay all of your taxes based on the highest tax bracket that matches your income. But thanks to marginal tax rates, that’s not the case. Instead, you pay a different rate for each part of your income that falls within the relevant tax bracket, and your marginal tax rate is the highest rate you qualify for based on your income. The progressive tax system helps to ensure that low-income individuals don’t pay income taxes at the same overall rate as high earners.
Let’s say Janet works in a job where the salary is $70,000. Because of the marginal tax rate system, she pays income tax at three different tax rates: 10%, 12%, and 22%. Janet accepts a new job where she will make $100,000 per year. Janet’s income now falls into four different income brackets. She will pay 10% on the first bit of her income, 12% on the next piece of her income, 22% on the part after that, and 24% on the top portion of her income. Even though Janet’s income hits the 24% tax bracket, she doesn’t have to pay 24% in income taxes on all of her income.
A marginal tax rate is like an exercise program…
The program has nine different levels, with each getting progressively harder as you go. By the time you graduate from the program, you’ve hit the highest level of difficulty. But you only had to do the hardest workout at the very end, not for the entire program.
The United States has a progressive income tax system. As your income rises, you pay a higher percentage of your earnings in taxes. For fairness, tax policy is based on the idea that people who earn higher incomes can afford to put more of their income toward taxes. This system helps to ensure that low-income individuals aren’t paying so much in taxes that they are left without enough to live on.
But thanks to marginal tax rates, just because you are in a higher tax bracket doesn’t mean you are paying the same rate for all of your income. Instead, you pay taxes on each dollar you earn at the rate of the tax bracket into which it falls. The only people who pay one rate of all of their income are those in the lowest income tax bracket.
For example, the highest federal single tax rate for 2019 income taxes (which are due in April 2020) applies to income for a single person of $510,301 or more. The tax rate for that bracket is 37%. People making $550,000 would fall into that tax bracket, but they wouldn’t pay a 37% income tax rate on all of their income. They would only pay 37% on every dollar they earn from $510,301 to $550,000. They would have some of their income taxed at each of the seven tax rates. And for the first $9,700 they make, they would pay the same rate as someone with an annual income of $5,000, which is the lowest rate of 10%.
Marginal tax rates apply a bit differently depending on how you file your taxes — whether you’re single, married filing jointly, married filing separately, or the head of the household. If you’re married and filing either jointly or separately, the income threshold for each tax bracket is higher. So for the highest tax bracket, rather than paying 37% on any dollar $510,301 or higher, married couples don’t pay a 37% tax rate until their combined income reaches $612,351. Additional taxes may also apply to income, such as FICA and state taxes.
Keep in mind your taxable income isn’t determined entirely by your salary. First, your taxable income could go up if you have money coming in from anywhere else. Your taxable income includes your wages and any bonuses you get at work. It also includes any income you might have from any freelance work or side jobs, unemployment benefits, as well as any profits, dividends, or interest you earn from investing.
Don’t worry, taxable income can also be reduced. That means you can lower how much you pay in taxes. When you’re filing your taxes, you can either take the standard deduction (a fixed amount that the government allows everyone to deduct automatically) or itemized deductions (meaning you figure out what deductions you qualify for).
Usually, you would only itemize if your deductions will exceed the amount allowed for the standard deduction. The standard deduction for 2019 taxes (which are due in April 2020) is $12,200 for single filers and married couples filing separately and $24,400 for married couples filing jointly. For 2020 taxes (which are due in April 2021), those numbers will increase to $12,400 and $24,800, respectively.
Some common deductions that you might be eligible for include contributions to a health savings account or Individual Retirement Account, student loan interest payments, mortgage interest payments, property taxes, and donations to charities.
Being familiar with the marginal tax rate system is important because it can give you a better understanding of how your financial decisions might affect your taxes. For example, you can figure out whether getting a higher-paying job might push you into a new tax bracket, or whether making a tax-deductible purchase might push you down into a lower tax bracket.
Individuals and businesses can also use the marginal tax rate system to help make financial decisions. For example, a business owner might invest in their business or their employees toward the end of the year, knowing that decision will help to push them into a lower tax bracket, lowering their total tax burden for the year.
For the 2019 tax year (meaning the taxes that are due in April 2020), there are seven tax brackets with seven different tax rates.
The marginal tax rates are:
Let’s take a look at what those tax brackets look like:
|Tax Rate||Single||Married, filing jointly||Married, filing seperately||Head of Household|
|10%||$0-$9,700||$0 to $19,400||$0 to $9,700||$0 to $13,850|
|12%||$9,701 to $39,475||$19,401 to $78,950||$9,701 to $39,475||$13,851 to $52,850|
|22%||$39,476 to $84,200||$78,951 to $168,400||$39,476 to $84,200||$52,851 to $84,200|
|24%||$84,201 to $160,725||$168,401 to $321,450||$84,201 to $160,725||$84,201 to $160,700|
|32%||$160,726 to $204,100||$321,451 to $408,200||$160,726 to $204,100||$160,701 to $204,100|
|35%||$204,101 to $510,300||$408,201 to $612,350||$204,101 to $306,175||$204,101 to $510,300|
|37%||$510,301 or more||$612,351 or more||$306,176 or more||$510,301 or more|
When it comes to taxes on your income for 2020 (meaning the taxes you’ll file by April 2021), the marginal tax rates remain the same, but the income thresholds for each bracket increase slightly. Here’s what those brackets will look like:
|Tax Rate||Single||Married, filing jointly||Married, filing seperately||Head of Household|
|10%||$0 to $9,875||$0 to $19,750||$0 to $9,875||$0 to $14,100|
|12%||$9,876 to $40,125||$19,751 to $80,250||$9,876 to $40,125||$14,101 to $53,700|
|22%||$40,126 to $85,525||$80,251 to $171,050||$40,126 to $85,525||$53,701 to $85,500|
|24%||$85,526 to $163,300||$171,051 to $326,600||$85,526 to $163,300||$85,501 to $163,300|
|32%||$163,301 to $207,350||$326,601 to $414,700||$163,301 to $207,350||$163,301 to $207,350|
|35%||$207,351 to $518,400||$414,701 to $622,050||$207,351 to $311,025||$207,351 to $518,400|
|37%||$518,401 or more||$622,051 or more||$311,026 or more||$518,401 or more|
While marginal tax rates are the tax rates that you pay on different parts of your income, an effective tax rate is the percentage of your total income that you owe the IRS for that year.
Let’s say you’re single, and you made $50,000 in 2019. As a result, your income falls into three different tax brackets: 10%, 12%, and 22%. But, after taking your standard deduction, let’s assume you only have to pay income taxes on $37,800 of income. Your income now only falls into two tax brackets: 10% and 12%. After calculating the taxes owed using the two different rates, the total amount of income tax you’ll pay the IRS for the year is $4,342.
To calculate your effective tax rate, divide your total tax bill by your pre-tax income (so $4,342 divided by $50,000). As a result, your effective tax rate is 8.7%. Your effective tax rate is a much more accurate representation of the percentage of your income that you pay in taxes. As you can see from our example, having a salary of $50,000 theoretically puts you in the tax bracket for the 22% marginal tax rate. But once we account for the standard deduction and calculate the amount you’ll pay in taxes in each of the brackets, the effective rate you pay in taxes is far lower than 22%.
You can also see from our example what an impact the standard deduction can have on your total tax liability. Imagine if there were no standard deduction, and you didn’t qualify for any individual deductions. You would have to pay income taxes on the full $50,000 you made in 2019. You would have paid 22% on the top chunk of your income, 12% on the middle piece, and 10% on the bottom part. Instead of paying $4,342 in income taxes, you would have paid nearly $6,900 — over $2,500 more than when you use the standard deduction. Your effective tax rate in this situation would be around 13.8% instead of the 8.7% you paid.
Luckily, the government has placed safeguards like marginal tax rates and the standard deduction to help taxpayers reduce their annual tax burden.
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