Have you ever heard someone say, “I don’t want to make any more money because it will put me in a higher tax bracket”? I have and just shake my head because most people don’t understand this concept. They mistakenly think that moving to a higher tax bracket will subject all of their income during the year to this higher rate.
Your marginal income tax rate is the rate at which you would pay tax on your next dollar of taxable income. It’s also the rate at which your last dollar of taxable income was taxed. Your marginal tax rate depends on your filing status and on the level of your taxable income.
It’s important to remember that the marginal tax rate is not the rate at which all of your dollars are taxed. If you enter a higher tax bracket, only the portion of your income that has crossed the new threshold will be taxed at the higher marginal income tax rate. The rest of your income will be taxed at the lower rates applicable at those thresholds.
For example: Assume Mark is unmarried and has $40,000 in taxable income in 2013. That will put him in the 25 percent marginal income tax bracket (see table below). That means that the first $8,925 of his taxable income will be taxed at 10 percent, the next $27,325 will be taxed at 15 percent, and only the remaining $3,750 will be taxed at 25 percent.
Generally speaking, a marginal income tax bracket is the income tax rate at which you’re taxed for a certain range of income. Brackets are expressed by their marginal tax rate. Currently, there are seven marginal tax rates, as follows. The income brackets to which each rate applies depend upon your filing status: married filing separately, married filing jointly or qualifying widow(er), head of household, or unmarried.
A sample of the marginal tax rate schedules for 2013 are as follows:
Single: $0 to $8,925
Married (filing jointly): $0 to $17,850
Single: $8,925 to $36,250
Married: $17,850 to $72,500
Single: $36,250 to $87,850
Married: $72,500 to $146,400
Single: $87,850 to $183,250,
Married: from $146,400 to $223,050,
Single: $183,250 to $398,350
Married: $223,050 to $398,350
Single: $398,350 to $400,000
Married: $398,350 to $450,000
Single: From $400,000
Married: From $450,000
Your marginal income tax rate is useful for calculating the income tax on additional income, such as the tax on a windfall or a year-end bonus. It’s also important for future tax planning. For instance, if you expect to be in a lower income tax bracket next year than you’re in this year, you might want to defer the recognition of some income until next year.
Although your marginal tax rate is a useful figure, your effective tax rate gives you a more complete picture of how much you’ll pay in income taxes over the course of a year. That’s because the effective tax rate takes into consideration any additional taxes you must pay (which increase your tax bite) and any income tax credits you’re entitled to (which lower your overall income tax liability). In contrast, your marginal tax rate involves only the specific income tax on your taxable income.
Your effective tax rate reveals the average rate of taxation for all of your dollars. It’s calculated as your total tax liability divided by your taxable income.
Example: Assume Mark is an unmarried taxpayer whose 2013 taxable income is $50,000. Mark is in the 25 percent marginal income tax bracket. His total tax owed is $6,608 (assuming no other variables). Therefore, Mark’s effective tax rate is approximately 13.2 percent ($6,608 divided by $50,000).
Taxes are not a fun part of life but bypassing income to save on taxes just seems like a bad financial plan.
Life is a journey; plan for it.
Neil A. Brown is a CPA and CFP with Burkett Financial Services in West Columbia. Reach him at www.uscneil.com or (803) 200-2272.