- Marginal tax rates on income taxes are based on tiered tax brackets. As your income rises and enters a higher tier, the tax rate for that higher income also increases.
- The IRS allows taxpayers deductions to income—whether standard or itemized—before arriving at taxable income on which marginal tax rates apply.
- With a little tax planning before the April 15 deadline, you might gain better control of what you pay in taxes while meeting other financial goals.
Is it really income tax time again? Whether you think about your taxes once a year prior to the April 15 deadline, or throughout the year to make sure you’re staying compliant with the Internal Revenue Service, knowing how your income is taxed helps you better understand your personal finances. We break down what marginal tax rates mean, starting with a discussion of tax brackets, and how these apply to you.
What are Marginal Tax Rates?
Two-thirds of Americans don’t understand much about U.S. federal income taxes, and 19% say they know “nothing at all” according to a recent Ipsos poll commissioned by NPR. You are very likely to be among the 86% who think that income tax rules are too complicated. To top it off, the recent Tax Reform and Jobs Act of 2017 implemented major changes to income tax laws, tax rates and more for individuals, married couples and businesses.
“Marginal tax rates” can be a complex concept, so let’s define what it means. The common definition is that “marginal rate is the tax rate the taxpayer pays on their next dollar of income earned, based on a progressive tax system.” Does that clear it up?
If not, that’s understandable. A discussion of marginal tax rates should start with what’s taxable income, and then the income tax brackets on which marginal tax rates are applied. Once you can visualize how taxable income is calculated, then how income flows into these tax brackets, the concept of marginal tax rates will be easier to understand.
Follow our step-by-step guide below, including the example of Julia and Rey, a married couple in California. From determining taxable income to applying the marginal tax rate in their case, you’ll see how the tax rules and tax brackets could apply for you and your family.
What’s Taxable Income? The First Step
The general rule to keep in mind is that the IRS considers all income as taxable, but they allow taxpayers specific exemptions and deductions against that income. In other words, consider any income you earn or receive as taxable unless the IRS says it’s not. To start, all these are to be reported to the IRS and income subject to taxes: Salary, wages, self-employment income, interest, dividends, capital gains, business income, rents, royalties, unemployment benefits, alimony (and more).
What isn’t taxable income for federal income taxes? Tax exempt income includes gifts and inheritances (up to IRS limits), child support, most healthcare benefits, qualified scholarships, municipal bond interest and more. Although these may be exempt from income taxes, the IRS might still want you to report them on your tax returns.
If this first step got you frowning, the next step may put a smile back on your face: claiming allowable tax deductions that reduce your taxable income. Then we’ll get to marginal tax rates.
What Are Income Deductions? The Next Step
Federal income tax rules allow for reductions to income, whether it’s from your total income subject to taxes or from the Adjusted Gross Income.
For example, pre-tax retirement contributions to your IRA or 401k can be a hefty deduction to your total income—tax policy wants to motivate Americans like you to take charge of your retirement by granting you a retirement contribution deduction. Other limited deductions from your total income include contributions to your Health Savings Account and student loan interest; if you’re self-employed, one-half of your self-employment taxes and health insurance, and limited contributions to your self-employment plan are also deductible from total income.
After all these deductions to your total income, you arrive at your Adjusted Gross Income from which you can then apply additional deductions. You can take either the standard deduction or an itemization of allowable deductions. You have only one choice, so choose whichever is greater that reduces your taxable income.
The 2017 tax law created a substantially larger standard deduction for taxpayers. This change may simplify tax filing for the average American who may not need to “itemize” like before. For 2019, the standard deduction is below; these amounts increase slightly for 2020.
An Example: Married Filing Jointly
Now let’s meet Julia and Rey, our married couple with kids who live in California. Combined they earn $240,000 from their jobs and contributed $20,000 to their 401ks and $2,000 to one HSA. Their total income is reduced to their “Adjusted Gross Income” of $218,000. Now, they can claim either a standard deduction of $24,400 or look for a larger deduction by itemizing. Which itemized deductions might apply to Julia and Rey?
The most common income tax deductions include mortgage interest on buying a house, state income and local property taxes (up to $10,000), and charitable contributions—all within IRS limits. After reviewing their statements, they see that they can claim $7,000 in mortgage interest and only the maximum allowable $10,000 in state and local taxes, for a total of $17,000 in itemized deductions. Our couple chooses the standard deduction of $24,400 since it provides them with a larger amount to reduce their taxable income. (Note that personal exemptions went away with the 2017 tax law changes, and has been replaced in part with the higher standard deduction.)
We arrive at Julia’s and Rey’s taxable income on their IRS Form 1040, of $193,600. Now we can finally talk about tax brackets and marginal tax rates!
Marginal Tax Rates: The Final Step
With Julia’s and Rey’s taxable income determined, we check to see how their income flows into the tax brackets and the assigned tax rates for each bracket. But first note that, like the standard deduction, there are different marginal tax brackets and rates for taxpayers who are single, married filing jointly, heads of households and married filing separately.
Instead of tax “brackets”, think of them as “tax buckets” where our couple’s income flows into each bucket like water; when that lower tax “bucket” is filled, their income flows into the next higher income bucket that’s taxed at a higher rate. So how does their $193,600 income flow into each bucket?
Our married couple’s taxable income, like water, first flows into the 10% bucket that taxes income between $0 and $19,399 at 10%. Any income that fills that bucket flows to the next bucket up to $78,949 that gets taxed at 12% until that bucket is filled, then flows into the next bucket up to $168,399 that gets taxed at 22%, and so on. Julia’s and Rey’s taxable income flows between the 10% and 24% tax brackets for a total tax across all the marginal tax rates of $34,813.
Although their highest marginal tax rate is 24%, their effective tax rate—total tax divided by taxable income—is much less at 18%. (They may also qualify for a few tax credits, but we’ll stop at taxes due for now.)
Although marginal tax rates get much attention, the effective tax rate is easier to understand and probably more relevant for you to know as the taxpayer. Your effective tax rate tells you what you actually owe in taxes as a percentage of your taxable income.
The above example uses ordinary or earned income, and a similar tiered system applies to capital gains taxes.
Does It Help to Know Income Tax Rates?
Perhaps the biggest takeaway from this illustration of marginal tax rates is to be aware of how you can take allowable deductions that reduce your overall income which in turn lowers your tax bill. For example, increasing your contributions for retirement or your HSA contributions before the tax filing deadline could keep your income from flowing into the next higher tax bracket.
Imagine if your status is “Married Filing Jointly”, and you find your taxable income is just above the $78,950 “bucket” in the table above where the marginal rate jumps from 12% to 22%. You’d have the chance to increase your pre-tax retirement or HSA contributions to lower your income and keep it in a lower tax bracket. You’d effectively decrease your income tax while increasing your retirement savings. Or, if you itemize, perhaps you’d rather give money to your favorite charity than to the government.
A little tax planning before the end of the year and the tax filing deadline can allow you to direct your hard-earned money the way you intend and not just to the IRS. When you do that, well then, won’t you be the smart one?