Marginal tax rate

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Marginal tax rate is the tax rate that will apply to the next marginal – or incremental – amount of income (or deductions). It is calculated by dividing the amount of additional taxes that will be due (or reduced) by the amount of income involved.[1]

The marginal tax rate is often the same as the individual's tax bracket, but not always.[note 1][note 2]

In investing, the word margin is the same as additional. To say it another way, this is the tax rate you would pay for each additional dollar amount earned (or reduced).[2]

Calculation

To calculate a marginal income tax rate, consider how much additional tax you would owe if you added "some amount" to your income. The smaller the amount the more precise the result - at least in theory - but a "useful" result is better than a "precise" result. Amounts of "$100" or "one paycheck" might be reasonable for analyzing current marginal rates. When projecting marginal rates in retirement, based on this year's contributions, using a larger amount such as the entire year's contribution might be reasonable.

For example, if your federal tax bracket is 25%, your state tax bracket is 8%, you aren't affected by credits, phase-outs, etc., and you don't itemize deductions, an extra $1 of income would cause you to pay 8 cents in state tax and 25 cents in federal tax, so your marginal rate is 33%. If you do itemize, the 8 cents in state taxes mean that you pay federal tax on only 92 cents, which is 23 cents of federal tax (23% = 92 cents * 25%) and a marginal rate of 31% = (23% + 8%).

Note that you may have a different marginal tax rate on different types of income. In the example above, your marginal tax rate on Treasury bonds (which are fully taxed by federal, not taxed by the state) is 25%. Your marginal tax rate on capital gains (which are taxed by the federal government at 15% but are probably still taxed at the full state rate) is 21% = (15% + 8%, minus the 2% = (8% * 25%) for the federal deduction of the state taxes).[note 3]

The actual marginal rate can be complicated if your taxes include credits, deductions, and exemptions which are phased out with income; if you are nominally in the 25% bracket but you lose $5 in tax credits for every additional $100 you earn, your marginal rate is actually 30%. For example, the phase-out of the child tax credit causes the following behavior for an MFJ (Married Filing Jointly) return with one eligible child:

Marginal tax rate with a Child Tax Credit Phase-Out[3] Marginal tax rate child tax credit phaseout.png

If you use tax software, you can compute your actual marginal rate by adding "some amount" (e.g., $100) to some category of your income and looking at the change in your tax bill. Here, practice can differ from theory. E.g., if you add only $1 your tax may not change at all: either from rounding (e.g., an extra $0.25 rounds down to $0) or because the IRS tax tables require a $50 change in taxable income to cause a change in tax due.

Special cases

Marginal rate of zero

A tax with a marginal rate of zero is a fixed-amount tax, such as a tax of $100 on every house rather than a percentage of the value of the house.

Flat rate tax

A flat rate tax has a constant marginal tax rate. Sales taxes and property taxes are normally flat, a fixed percentage of the value. Income taxes in some states are almost flat; typically, there is a fixed amount (such as a standard deduction) which is exempt from tax, and everyone making more than that fixed amount pays the same marginal tax rate, so the average tax rate varies.

Common examples of high marginal rates

Taxation of Social Security benefits causes many moderate-income retirees to be subject to a much higher marginal tax rate than their tax bracket. If you are in the range in which Social Security becomes taxable, each additional $1 of income causes an extra 50 or 85 cents of Social Security to be taxable at the same tax rate, until 85% of the whole benefit is taxable. If you are in the 15% bracket and each $1 causes an extra 85 cents to be taxable, that extra $1 of income increases your taxable income by $1.85, with 27.75 cents due in tax giving you a marginal tax rate of 27.75%. If you are in the 25% bracket and each $1 causes 85 cents to be taxable, your marginal tax rate is 46.25%.

Another unusually high marginal rate is the result of the 0% tax rate on qualified dividends and capital gains at low incomes. There is a taxable-income level X which is the top of the 15% bracket. Ordinary taxable income up to X is taxed at a marginal rate of 15%, and ordinary income above X is taxed at a marginal rate of 25%. Qualified dividends and capital gains are then added to your ordinary taxable income; the amount which is still below X is taxed at 0%, and the amount above X is taxed at 15%. Thus, if your ordinary-taxable income is less than X but your total taxable income is more than X, your marginal tax rate is 30%. Every additional $1 of ordinary income is below X and thus taxed at 15%, but it also moves $1 of qualified dividends from below X to above X, and that $1 is now taxed at 15% rather than 0%.

Combining the above two items can produce even higher rates. For a single person age 65, with $12,000 in qualified dividends, $27,000 from social security, and $24,000 in traditional IRA distributions, the marginal rate for more[3]

  • traditional IRA distributions is 55.5%
  • qualified dividends is 40.5%
  • social security income is 12.75%

Not all high marginal rates are unfavorable. E.g., due to the saver's and earned income credits, marginal savings rates can be much higher than the tax bracket would suggest.

Using the marginal rate for investment decisions

Due primarily to the calculation of various tax credits, the marginal savings rate of a 401(k) or tIRA contribution may differ from the marginal tax rate of increased income, even for the same base income.

After-tax value

The marginal tax rate determines the relative after-tax value of different investments. If your marginal federal tax rate is 25%, then a corporate bond fund with a 4% yield and a municipal bond fund with a 3% yield have the same after-tax value to you. It is important to use the marginal tax rate for the appropriate type of income; if the municipal bond fund is from your own state and is exempt from the 8% state tax as well, then you have a 31% marginal tax rate on the corporate fund and 0% on the municipal fund, and thus the municipal fund has a better after-tax yield.

Traditional vs. Roth

Deciding between traditional and Roth contributions is another use for marginal rates. See that article for more details. For this use, one needs to pick "some amount" of contribution for the marginal savings rate, then use the annual withdrawal resulting from that contribution as "some amount" for the marginal withdrawal rate. The contribution amount is often taken as a year's worth but one can use smaller amounts if desired.

One should also recognize that marginal rates don't always increase as income increases, nor always decrease as pre-tax contributions increase. In those cases, one should look at different values of "some amount" to determine the best strategy.

E.g., take a couple making $54K/yr with two young children. In 2016, that puts them in the "15% bracket." Yet, due to various combinations of the saver's and earned income credits, as they increase 401k contributions from $0 to $18,000 their marginal savings rates (calculated a dollar at a time) go through regions of 25%, 46%, 36%, 31%, and 21% - plus some spikes due to tiers in the saver's credit. Their maximum marginal savings rate of 33.4% comes when "some amount" of 401k contribution is $14,000. In graphical form:

Example 1: Tax Rate vs. 401(k) Contributions[3] Marginal tax rate MFJ savings.png

Compare the above couple's situation to a single person making $54K/yr. That person is in the "25% bracket" with a marginal savings that is also 25% - until $6,000 has been contributed to a 401k, at which point both the tax bracket and marginal savings rate drop to 15%.

Example 2: Tax Rate vs. 401(k) Contributions[3] Marginal tax rate single savings.png

FAQ

Tax Bracket

Q. Last year I paid 7% of my income in income taxes. Is this my marginal tax rate? Does this mean I'm in the 10% tax bracket? Or am I in the 28% tax bracket because I made $100,000 and my filing status is single and the 28% tax bracket is between $87,850 to $183,250 in the year 2013?

A. If your gross income was $100,000 and you paid $7,000 in taxes, then you did pay 7% of your income in taxes. While that figure might be interesting to know, it doesn't necessarily help you make borderline decisions in the way that knowing your marginal tax rate can.

To know which tax bracket you're in, look at your taxable income (not your salary) on line 43 of your 1040 tax return, and then cross reference that against IRS tax tables and your filing status.[4][5]

Appendix: Marginal rates explained

In finance, the term "marginal" means derivative. A marginal tax rate is one example of a partial derivative.[note 4] We show why it's a derivative and then why it's partial. A full derivative results when the two variables are related through a third variable.[6]

As a derivative

Applying calculus principles, the equivalence of marginal and derivatives is a matter of definition as described below:

Your income increases from $20,000 to $20,100; which provides you with $100 of extra income. This additional $100 of income results in $15 of additional tax. The marginal rate is therefore 15% = $15 / $100. Stated another way, your marginal tax rate at an income of $20,000 is 15%.

As a partial derivative

A partial derivative indicates that the tax is not a function of one income, e.g. total income, but several different types of income. For example, wages and capital gains. So we have not a function of one variable tax(income) but a function of two variables tax(wages,gains).

A partial derivative of a function of two or more variables is just the derivative if we change one variable and leave the others constant. This is how marginal tax rates are usually calculated. Refer to the previous example. At an income of $20,000, the marginal tax rate on wages is 15% because an extra $100 of wages increase taxes by $15. However, the marginal tax rate on capital gains is 0% because an extra $100 of capital gains results in $0 extra tax.

As a full derivative

Now, let's convert some of the wages into capital gains (through various investments). Both wages and capital gains are a function of a third variable, the proportion chosen to allocate to gains, x, which results in a form of tax(wage(x),gain(x)). Looking how this tax changes as the allocation changes results in a full derivative in the case of tax with respect to x (formally as d(tax(x))/dx).

Notes

  1. Since the income tax structure includes various types of income, deductions, exclusions, credits, and taxes that are not subject to the same treatment under tax laws, the marginal tax rate is not always apparent. See: Individual Income Tax Rates and Shares, 2010, Statistics of Income Bulletin, Winter 2013, page 23 (printed), from the IRS.
  2. A "tax-bracket" is not formally defined, but inspection of US law shows the intended usage. Note that the term "rate bracket" is also used. From 26 U.S. Code § 1 - Tax imposed:
    • (f) Phaseout of marriage penalty in 15-percent bracket;
    • ...maximum dollar amounts for each rate bracket...
    • (7) Special rule for certain brackets
  3. To explore this concept in more detail, consider a couple a married couple with $100,000 salary, $10,000 qualified dividends, and $30,000 in deductions and exemptions.
    • $5100 qualified dividends in 25% bracket, taxed at 15%
    • $4900 qualified dividends in 15% bracket, not taxed
    • $51,550 regular income in 15% bracket, taxed at 15%
    • $18,450 regular income in 10% bracket, taxed at 10%
    • $30,000 deductions and exemptions, not counted in bracketing
    Now, they earn an extra $1000 in regular income and revise their qualified dividends ($10,000 total) as follows:
    • $6100 qualified dividends in 25% bracket, $1000 more taxed at 15%
    • $3900 qualified dividends in 15% bracket, not taxed
    • $52,550 regular income in 15% bracket, $1000 more taxed at 15%
    • $18,450 regular income in 10% bracket, taxed at 10%
    • $30,000 deductions and exemptions, not counted in bracketing
    As shown in the spreadsheet below, the tax rises by $300, so their marginal tax rate is 30%.


    (View Google Spreadsheet in browser, then File --> Download as to download the file.)

  4. Understanding calculus can give insight into concepts like marginal demand and marginal supply.
    Also note that rate means change, such as a change over a period of time. For example, interest paid over time is an interest rate.

See also

References

External links

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