Do you know your marginal tax rate?

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2sls
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Do you know your marginal tax rate?

Post by 2sls » Mon May 14, 2018 5:27 pm

I am asking (and partially answering) this question because it seems like a fundamental input into decision making involving any type of tax arbitrage or extra income earning opportunities. Am sharing some data and calculations in order to improve the quality of the discussion and to invite improvements from more experienced posters as I'm sure others have already done similar calculations.

This is for a MFJ couple (all information as of 2018 except I haven't factored in the new SALT limitations)
a) AGI is ~ 350-400K primarily W2 (32% marginal federal bracket)
b) 20K of mortgage interest annually from home purchase pre 2017.
c) Our marginal state tax rate ~ 10% (our state does not care about source of income so no extra calculations for further deductions)

Here are the calculations for the marginal tax rate of an additional dollar of earnings from:
i) long term capital gains = 28.8% [15% (lt gains bracket] + 10% (state) + 3.8% (net investment tax)]
ii) short term capital gains = 45.8% [32% (federal bracket) + 10% (state) + 3.8% (net investment tax)]
iii) ordinary dividends = short term capital gains
iv) qualified dividends = 25% [15% (lt gains bracket] + 10% (state) ]
v) interest income = short term capital gains
vi) wage income = 44.35% [32% (federal) + 10% (state) + 2.35% (medicare)]

Now I know these are not entirely accurate because I haven't taken into account the SALT deduction and other stuff I don't even know about it's probably within 1-5% of the truth.

What I learned from this exercise is that for our situation
i. Interest income from a regular savings account is terrible post-tax relative to a tax-exempt bond fund like VWIUX
ii. Ordinary dividends are really dragging down our post-tax performance but I haven't found a comparable fund that has similar risk/return without them. I also haven't found a good tool that compares funds on a post-tax basis as opposed to a pre-tax basis.
iii. Given a choice, I should focus on non W2 sources of additional income (duh!)

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Re: Do you know your marginal tax rate?

Post by jebmke » Mon May 14, 2018 5:39 pm

Depending on the situation, the bracket rates are not the marginal rate. Thus, for example, the existence of the infamous 30% federal marginal rate - which doesn't even appear in the tax tables. I calculate my marginal tax rate heuristically using tax software. The only way to do it IMO.
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Re: Do you know your marginal tax rate?

Post by OAG » Mon May 14, 2018 6:50 pm

Quicken will give you that number. Or a simple calculation is taxes divided by total income (example $40K of taxes divided by $400K total income equals 10% which is the effective rate for those numbers). So a single dollar is worth $.90 since 10% goes to taxes. A bit simplistic and changing variables will change the rate.


Edited to correct "effective" in place of "marginal". My error thinking that OP was looking for the effective rate of taxation since I read his post as saying he actually knew his marginal rate.
Last edited by OAG on Wed May 16, 2018 7:13 pm, edited 1 time in total.
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Re: Do you know your marginal tax rate?

Post by Clever_Username » Mon May 14, 2018 7:08 pm

I'm confused here; do you mean marginal or effective? I know my marginal rate (rate at which the next dollar will be taxed) and I compute my effective rate when I file taxes each year, but I don't know that number offhand.
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Re: Do you know your marginal tax rate?

Post by Daryl » Mon May 14, 2018 7:47 pm

Yes - 22% (For W-2 Sources), a little less for 1099 (INT/DIV)

Effective Rates are a little harder to calculate. What is the denominator? Adjusted Livesoft Income?

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Re: Do you know your marginal tax rate?

Post by grabiner » Mon May 14, 2018 8:06 pm

OAG wrote:
Mon May 14, 2018 6:50 pm
Quicken will give you that number. Or a simple calculation is taxes divided by total income (example $40K of taxes divided by $400K total income equals 10% which is the marginal rate for those numbers). So a single dollar is worth $.90 since 10% goes to taxes. A bit simplistic and changing variables will change the rate.
This is the average tax rate, not the marginal tax rate. If you pay $40K in taxes with $400K income, and $44K in taxes with $410K income, then your marginal tax rate is 40%.

And that is the relevant number for investment decisions. For example, at a 40% marginal rate, moving money from corporate bonds yielding 5% to in-state municipal bonds yielding 3% would be break-even in income, and probably a reduction in risk. (Note the "in-state"; the marginal tax rate on out-of-state municipal bonds is not zero in most states.)
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Re: Do you know your marginal tax rate?

Post by Bacchus01 » Mon May 14, 2018 8:11 pm

OAG wrote:
Mon May 14, 2018 6:50 pm
Quicken will give you that number. Or a simple calculation is taxes divided by total income (example $40K of taxes divided by $400K total income equals 10% which is the marginal rate for those numbers). So a single dollar is worth $.90 since 10% goes to taxes. A bit simplistic and changing variables will change the rate.
That’s exactly how NOT to calculate marginal tax rate

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Re: Do you know your marginal tax rate?

Post by triceratop » Mon May 14, 2018 9:13 pm

Technically you've computed a number for your marginal tax rate which is only valid on December 31, or the date of your last dollar of taxable income received.

And, yes, I do. My December 31 marginal tax rate for 2017 was 18%. This year is tricky because I move onto W-2 income mid-year so there will be FICA taxes beginning mid-year. What that means for my marginal tax rate is murky; fortunately it doesn't result in any actionable changes.
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FiveK
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Re: Do you know your marginal tax rate?

Post by FiveK » Mon May 14, 2018 9:46 pm

2sls wrote:
Mon May 14, 2018 5:27 pm
I am asking (and partially answering) this question because it seems like a fundamental input into decision making involving any type of tax arbitrage or extra income earning opportunities.
Indeed it is!
This is for a MFJ couple (all information as of 2018 except I haven't factored in the new SALT limitations)
a) AGI is [exactly 365K with 350K from] W2 (32% marginal federal bracket)
b) 20K of mortgage interest annually from home purchase pre 2017.
c) Our marginal state tax rate ~ 10% (our state does not care about source of income so no extra calculations for further deductions)
d) $5K in some combination of STCG, non-qualified dividends, and interest.
e) $10K in LTCG
Here are the calculations for the marginal tax rate of an additional dollar of earnings from:
i) long term capital gains = 28.8% [15% (lt gains bracket] + 10% (state) + 3.8% (net investment tax)]
ii) short term capital gains = 45.8% [32% (federal bracket) + 10% (state) + 3.8% (net investment tax)]
iii) ordinary dividends = short term capital gains
iv) qualified dividends = 25% [15% (lt gains bracket] + 10% (state) ]
v) interest income = short term capital gains
vi) wage income = 44.35% [32% (federal) + 10% (state) + 2.35% (medicare)]
i) ~28.5%, due to the "allocated state/local tax deduction" reducing the income for the Net Investment Income Tax (NIIT - form 8960).
ii) ~45.5%, for the same reason as i).
iii) Yes, same as ii).
iv) Same as i). Qualified dividends are also subject to the NIIT.
v) Yes, same as ii).
vi) Yes, 44.35%.
vii) 401k contributions: 42% tax saving for the first $10K; 34% tax saving for the remaining $27K.

It has already been mentioned that the average (aka effective) tax rate is useless for investment decisions.

It is also worth noting that the "rate on the next dollar" is useful only if one is limiting one's investment alternative to a single dollar. The useful marginal rate uses "the investment amount under consideration" as the denominator, while the change in tax for that investment amount is the numerator.

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Re: Do you know your marginal tax rate?

Post by SQRT » Tue May 15, 2018 4:39 am

For those who might be interested in comparing.

Marginal tax rates in Canada are pretty easy to calculate as the maximum rates are hit pretty low (around $200,000-$300,000 in earnings) depending on the province of residence. For high earners, they often look at taxes the opposite way compared to lower earners.

For example if your income will always be well in excess of the threshold for the maximum rate, it probably makes more sense to view your total tax expense as the max rate offset by a fixed dollar amount representing the tax savings of the lower tax brackets. For an individual in Canada this total savings is around $30,000 per year depending on province of residence. So for high earners (over $300,000 in income) the marginal rate will always equal the maximum rate. These rates are different for the three main types of income: regular income, dividends, and capital gains.

In Alberta the max tax rate on “regular” income is a combined 48%. (Canadians generally view their tax rates as the combined rates because the federal and provincial tax returns are integrated, except Quebec). So if, for example, my income (all regular, no divs or cap gains) is $1,000,000 my marginal tax rate is 48% for my income over $300,000. I would save about $30,000 for the lower rates on the lower brackets. Therefore on $1,000,000 of income my total taxes would approximate (.48X$1,000,000)-$30,000 or about $450,000. Quite a lot ,eh? Now most people would have charitable donations and medical expenses that would offset this a bit. But these are calculated as tax credits (at a low rate) not income deductions.

I think the Canadian system is simpler than the US one but generally incorporates higher rates.
Last edited by SQRT on Tue May 15, 2018 7:15 am, edited 2 times in total.

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Re: Do you know your marginal tax rate?

Post by The Wizard » Tue May 15, 2018 5:23 am

I have three different Federal marginal tax rates:
1) one for $100 more SS income
2) one for $100 more qualified dividend income
3) one for everything else (1099-R and W-2 mainly)...
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teen persuasion
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Re: Do you know your marginal tax rate?

Post by teen persuasion » Tue May 15, 2018 7:20 am

Our marginal rate is more dependent on whether we hit retirement contribution maximums and on refundable credit phaseouts, along with nonrefundable credits causing discontinuities.

Without any retirement or HSA contributions, we'd be in the 12% federal bracket + 4% state. Contributions get us down to the 10+4% brackets. The larger effect of contributions is on the EITC: the EITC phaseout rate is 21%. Our state matches EITC at 30%, for an added effective phaseout rate of 6.3%. So every $ contributed to traditional 401k/HSA accounts nets us 27.3% more in refundable credits, plus avoids 14% in taxes, for a total of 41.3%.

Muddying the issue: those nonrefundable credits. We end up in the zero federal bracket, the last bits of federal tax get wiped out by either Retirement Saver's credit, or the nonrefundable portion of AOTC, and in 2018 the nonrefundable portion of the higher CTC. There's also the 7.65% FICA avoided for HSA contributions, which you could view as bumping the top rate to 48.95% if you mentally stack the HSA contributions on top of the retirement contributions. I prioritize HSA before retirement contributions, so I really don't stack them that way in my mind, but you could view it either way.

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Re: Do you know your marginal tax rate?

Post by Cyclesafe » Tue May 15, 2018 8:20 am

The easiest way to determine one's marginal tax rate is to run tax software for the next $1000 and the last $1000 of the various sources of income. For earned income, FICA and Medicare costs have to be factored in separately. Note: using an incremental $100 can give rounding errors.

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Re: Do you know your marginal tax rate?

Post by CurlyDave » Tue May 15, 2018 8:40 am

OAG wrote:
Mon May 14, 2018 6:50 pm
Quicken will give you that number. Or a simple calculation is taxes divided by total income (example $40K of taxes divided by $400K total income equals 10% which is the marginal rate for those numbers). So a single dollar is worth $.90 since 10% goes to taxes. A bit simplistic and changing variables will change the rate.
This is the effective tax rate, not the marginal tax rate.

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Re: Do you know your marginal tax rate?

Post by SQRT » Tue May 15, 2018 9:25 am

CurlyDave wrote:
Tue May 15, 2018 8:40 am
OAG wrote:
Mon May 14, 2018 6:50 pm
Quicken will give you that number. Or a simple calculation is taxes divided by total income (example $40K of taxes divided by $400K total income equals 10% which is the marginal rate for those numbers). So a single dollar is worth $.90 since 10% goes to taxes. A bit simplistic and changing variables will change the rate.
This is the effective tax rate, not the marginal tax rate.
Or even a better description would be “average tax rate for the year”. Agree it’s not the marginal tax rate.

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Re: Do you know your marginal tax rate?

Post by randomizer » Tue May 15, 2018 9:32 am

I know my marginal, but only figure out my effective at the end of the tax year.
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Re: Do you know your marginal tax rate?

Post by CurlyDave » Tue May 15, 2018 9:44 am

SQRT wrote:
Tue May 15, 2018 9:25 am
CurlyDave wrote:
Tue May 15, 2018 8:40 am

...This is the effective tax rate, not the marginal tax rate.
Or even a better description would be “average tax rate for the year”. Agree it’s not the marginal tax rate.
The accounting world has specific meanings for certain terms. "Effective tax rate" is accountant speak for average tax rate for the year. "Marginal tax rate" is the tax rate on an additional $1.00 of income.

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Re: Do you know your marginal tax rate?

Post by SQRT » Tue May 15, 2018 10:54 am

CurlyDave wrote:
Tue May 15, 2018 9:44 am
SQRT wrote:
Tue May 15, 2018 9:25 am
CurlyDave wrote:
Tue May 15, 2018 8:40 am

...This is the effective tax rate, not the marginal tax rate.
Or even a better description would be “average tax rate for the year”. Agree it’s not the marginal tax rate.
The accounting world has specific meanings for certain terms. "Effective tax rate" is accountant speak for average tax rate for the year. "Marginal tax rate" is the tax rate on an additional $1.00 of income.
Ok as a retired CPA I should have known that I guess.

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Re: Do you know your marginal tax rate?

Post by trueblueky » Tue May 15, 2018 11:16 am

CurlyDave wrote:
Tue May 15, 2018 9:44 am
SQRT wrote:
Tue May 15, 2018 9:25 am
CurlyDave wrote:
Tue May 15, 2018 8:40 am

...This is the effective tax rate, not the marginal tax rate.
Or even a better description would be “average tax rate for the year”. Agree it’s not the marginal tax rate.
The accounting world has specific meanings for certain terms. "Effective tax rate" is accountant speak for average tax rate for the year. "Marginal tax rate" is the tax rate on an additional $1.00 of income.
If you have low enough income to use the tax tables, the tax is in steps. You could add $10 of income and owe no more tax, or you could add $1 and pay $7 more in tax.

I think trying $1000 more in various types of income, one at a time, is more useful.

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Re: Do you know your marginal tax rate?

Post by Kevin M » Tue May 15, 2018 12:08 pm

jebmke wrote:
Mon May 14, 2018 5:39 pm
Depending on the situation, the bracket rates are not the marginal rate. Thus, for example, the existence of the infamous 30% federal marginal rate - which doesn't even appear in the tax tables..
Which is now the 27% marginal tax rate as of 2018: 12% + 15% (QD/LTCG pushed from 0% to 15%). That's my federal marginal tax rate for 2018, and I expect state to be 8%.

Agree that tax software is the way to go, since it factors in deduction and credit phaseouts, and all the other stuff you might not think about. It's nice when the tax software result agrees with what you've figured out analytically.

One problem with tax software though is that using 2017 tax software for 2018 won't be accurate, so you really need to wait for 2018 tax software for this.

I usually use $1,000 incremental income, but if $1,000 pushes you into a higher marginal rate, and you're making decisions about more than $1,000 of marginal income, you need to bump it by an additional $1,000 to see the changes at the higher income level.

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Re: Do you know your marginal tax rate?

Post by Artsdoctor » Tue May 15, 2018 1:18 pm

2sls,

You're right to question whether people know their marginal tax rates. Most do not, although many think they do.

Your income is going to make things a little more complicated, and figuring out your rate for 2018 will be tough because so much has changed (for example, you'll probably not be subject to the AMT this year but may have been last year).

Furthermore, you'll probably notice that you're subject to NIIT on your investments. Consequently, you have TWO marginal tax rates: one would be for earned income and one would be for investment income.

The best way for someone in your situation to figure out your marginal tax rate is to use a software program. You can guess if your income puts you in the middle of particular bracket since some brackets are relatively large. However, a program will help.

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Re: Do you know your marginal tax rate?

Post by grabiner » Tue May 15, 2018 9:31 pm

teen persuasion wrote:
Tue May 15, 2018 7:20 am
There's also the 7.65% FICA avoided for HSA contributions, which you could view as bumping the top rate to 48.95% if you mentally stack the HSA contributions on top of the retirement contributions.
In your low tax bracket, the FICA avoided is likely to be a net loss; $1 of saved FICA costs you more Social Security than $1 more invested will earn you in retirement income. Thus, you might be better contributing to your HSA outside of payroll deduction. See Payroll Deduction on the wiki for more details.

(It's still better to contribute to the HSA than to the 401(k) if you can't max both out, since the HSA has a tax subsidy.)
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Re: Do you know your marginal tax rate?

Post by nisiprius » Tue May 15, 2018 9:36 pm

I use tax software to do my taxes. One of my last steps is to prepare a second tax return in which I simply increase one of my income entries by $100 and see how much my taxes increase. That gives me my marginal tax rate.
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Re: Do you know your marginal tax rate?

Post by SQRT » Wed May 16, 2018 5:11 am

nisiprius wrote:
Tue May 15, 2018 9:36 pm
I use tax software to do my taxes. One of my last steps is to prepare a second tax return in which I simply increase one of my income entries by $100 and see how much my taxes increase. That gives me my marginal tax rate.
I do this as well. But it really depends on the type of income you add and always conforms to my understanding of the rates in effect. What’s more interesting to me is changing the province of residency. That is a significant impact and difficult to estimate accurately.

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Re: Do you know your marginal tax rate?

Post by teen persuasion » Wed May 16, 2018 7:10 am

grabiner wrote:
Tue May 15, 2018 9:31 pm
teen persuasion wrote:
Tue May 15, 2018 7:20 am
There's also the 7.65% FICA avoided for HSA contributions, which you could view as bumping the top rate to 48.95% if you mentally stack the HSA contributions on top of the retirement contributions.
In your low tax bracket, the FICA avoided is likely to be a net loss; $1 of saved FICA costs you more Social Security than $1 more invested will earn you in retirement income. Thus, you might be better contributing to your HSA outside of payroll deduction. See Payroll Deduction on the wiki for more details.

(It's still better to contribute to the HSA than to the 401(k) if you can't max both out, since the HSA has a tax subsidy.)
Thanks for the input. It's a good point, and I've done the math to compare the lost SS benefits. If the only difference were the lost SS, you'd be correct. However, payroll HSA influences the EITC and EFC differently than contributions outside of payroll.

EITC is tested on both line 7 wages and agi, and you get the lower credit (usually higher # gives lower credit, but depends on where you are on the phase in/phaseout ramp). Contributions thru payroll keep these two tests as close as possible.

On the FAFSA, payroll HSA contributions are "invisible", while line 25 HSA deductions are added back to available income.

So for a $6900 HSA contribution, we save
$ 527.85 FICA (7.65%)
$1449.00 EITC (21%)
$ 434.00 state EITC (30% of fed EITC)
$1518.00 EFC (our 22% bracket)

$3928.85 total, which ultimately we put in Roth IRAs

Our lost SS benefit would be (6900/420)*.32 = 5.25 per month at FRA.
Compare that to 4% of the Roth IRA contribution = 157.85, or about $13 per month.

Please poke holes in my viewpoint if I'm barking up the wrong tree!

ETA: Just realized I forgot an additional 50% of SS benefit for my spousal benefit, so an additional loss of $2.62. So $7.87 loss vs $13 gain.

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Re: Do you know your marginal tax rate?

Post by 2sls » Fri May 18, 2018 10:16 pm

Thanks for all the feedback everyone. I realized a bit later after this exercise that simulating via software is probably closer to the truth and easier especially since I completely ignored the new AMT.

I was primarily motivated to learn the tax code a little better and to do some post-tax comparisons of bond funds and therefore couldn't just wait until the new software rolled around.

And thank you for correcting some of my calculations :)

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Re: Do you know your marginal tax rate?

Post by FiveK » Fri May 18, 2018 10:31 pm

2sls wrote:
Fri May 18, 2018 10:16 pm
...simulating via software is probably closer to the truth and easier....
And if you want to see graphs of marginal rates over a wide range of income/contribution amounts, see the personal finance toolbox spreadsheet.

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Re: Do you know your marginal tax rate?

Post by 2sls » Fri May 18, 2018 11:29 pm

You just blew my mind! Never imagined a mini Turbotax\tax planner replicated inside Excel. I would have paid money for a tax simulator addon that reads the data from Turbotax.

OK back to the spreadsheet - this is too much fun.

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