If you’re single and you earn $100,000 per year, you are in the 24% tax bracket, so that means you should be paying $24,000 per year in federal income tax, right? Well, no, it’s not that simple. In fact, your actual tax liability will probably be much less. And that’s because the U.S. has what is known as a “progressive” income tax system. But, don’t worry, this article isn’t about politics.
The progressive tax system as adopted in the U.S. is a tiered structure of brackets with increasing tax rates as a taxpayer’s earned income goes up.
You can think of it like walking up a seven-story staircase, with each flight of stairs representing a new income threshold and a higher rate of taxation. Beginning at the ground floor, everyone pays the same low rate.
As some taxpayers ascend to higher floors, they pay a higher rate when they go up, but their rates for the previous floors remain the same.
2018 Tax Brackets for Ordinary Income (1)
|Percent Taxed||Single Filer||Married Filing jointly|
|10%||$0 - $9,525||$0 - $19,050|
|12%||$9,525 - $38,700||$19,050 - $77,400|
|22%||$38,700 - $82,500||$77,400 - $165,000|
|24%||$82,500 - $157,500||$165,000 - $315,000|
|32%||$157,500 - $200,000||$315,000 - $400,000|
|35%||$200,000 - $500,000||$400,000 - $600,000|
As a result, a taxpayer’s “effective rate” (the actual ratio of income to taxes paid) will not be equal to the rate for the floor the taxpayer ends up on because he or she paid lower rates at the lower levels.
While it’s useful to know your effective tax rate when budgeting and making certain financial decisions, it won’t accurately predict the cost of continuing your climb up the staircase. For that, you need to base your calculations on your “marginal rate” – the actual tax liability incurred for the next dollar you earn.
In our staircase analogy, your marginal rate is equal to the rate for the floor you’re currently on. Or, in real life terms, your marginal rate is your current tax bracket based upon your anticipated income.
Increase in Income vs Time
Knowing your marginal rate comes in handy for financial planning because it lets you know the true cost an increase in income will have on your tax liability. It is also valuable when you take into account the cost of the money on your time.
Let’s say you have an opportunity to earn an additional $10,000 by doing a side-job or taking on an after-hours project at work. And, to decide whether it’s worth the trouble, and more importantly, the use of your time, you want to know how much of the pay you will actually take home after taxes.
If you make the calculation using your effective rate, you will underestimate the taxes due because your regular salary was already taxed at the lower rates. Returning (for the last time) to our previous analogy, the additional income will be taxed based upon the floor you have already reached, not the amount you paid while getting there.
It is good to take advantage of opportunities that allow you to earn more income. However, sometimes the additional income is not worth the time; time that can be “spent” on other pursuits, such as family, friends and other more important life pursuits.
401k and IRA Contributions
In addition to employment-related decisions, the marginal rate concept is also useful in determining the optimal amounts and timing for any 401K or IRA contributions.
If your current marginal rate is fairly low, the tax savings of a retirement account contribution won’t be as substantial as if you had a higher marginal rate – though, of course, that doesn’t mean it’s a bad idea. Conversely, if you’re in a relatively higher bracket, the tax savings realized goes up.
Sometimes, you can adjust your contributions to reduce your marginal rate in a given year by keeping your taxable income in a lower bracket. Along the same lines, you can time contributions to occur in years in which your marginal rate is higher.
Does the Marginal Tax Rate Disincetivize Productivity?
From a policy perspective, examining marginal rates can be helpful in measuring the economic incentives or disincentives that a policy will provide to taxpayers at different levels.
In theory, a taxpayer with a lower marginal rate has a greater incentive to work extra hours or expand a business – and less incentive to use tax shelters – than if the taxpayer’s marginal rate is higher.
Proponents of a flat tax, for instance, argue that higher marginal rates under a progressive tax system disincentivize increased productivity and innovation as the net economic benefit of greater earnings decreases.
Hence, under the progressive tax structure, $10,000 in additional earnings is worth more in real terms to someone in the 12% bracket than to someone in the 32% bracket because the former actually gets to keep more of the money earned.
Critics of this line of thinking maintain that the overall economic impact is negligible and that the societal benefits of tempering income inequality are worth a slight decrease in productivity.
Marginal Tax Rate Example
But, rather than go too far out into left-field on the policy implications and the politics involved, we’ll take a look at how the concept of a marginal tax rate might impact real taxpayers under the 2018 tax rates.
Let’s say a married couple who have two kids and file jointly have a combined household income of $105,000. Their first $24,000 in earnings are essentially tax free due to the $24,000 standard deduction for a married couple filing jointly (raised from $12,700 in 2017). Their next $19,050 will be taxed at the lowest rate of 10%, so they’ll pay $1,905. Then, they’ll pay 12% – or $7,002 – on their next $58,350, and 22% – or $792 – on the last $3,600.
Overall, the couple will owe $9,699 in income tax on their $105,000 combined income, or an effective rate of 9.2%. However, they are eligible for $2,000 (increased from $1,000 in 2017) in child tax credits for each of their two children, so they will actually pay $5,699 in income taxes, or an effective rate of 5.4%.
Now, let’s say the wife is offered a promotion that comes with a $10,000 pay raise, and the couple want to know the opportunity cost of whether the increased take-home pay is worth the larger workload.
As your money earned is taxed at a higher rate, the time it takes to make additional income must be weighed, as there is a diminishing return on the money vs the time expenditure involved in its production.
In this example, if they use their effective rate of 5.4% to make the calculation, they’ll conclude that the raise will result in only $540 in additional taxes. Unfortunately for them, though, the actual tax increase will be substantially larger because their current combined income already puts them in the 22% bracket. So, their marginal rate is 22%. (By way of comparison, their marginal rate would have been 25% under the 2017 rates.)
Instead of $540, they will end up owing $2,200 in additional income tax, with a corresponding decrease in the take-home portion of the higher salary. Of course, the promotion still may be well worth the effort, but it’s always best to make a decision based upon accurate information.
Let’s conclude our hypothetical with a curve ball and say the husband earns his portion of the family’s income, which we will say is $50,000, through self-employment. Because he is self-employed, he doesn’t have an employer deducting FICA taxes, and he therefore has to pay the self-employment tax.
The self-employment tax, which is included within a taxpayer’s income tax return, is designed to ensure that self-employed workers and small business owners chip in for Medicare and Social Security. As both employer and employee, the husband will have to pay the full 15.3% combined rate since he doesn’t have an employer paying half.
To calculate self-employment tax, self-employed earnings are first multiplied by 0.9235, so the husband’s taxable self-employment income is $46,175. The amount of the tax is 15.3% of that, increasing the couple’s tax burden by $7,065.
Fortunately, the IRS allows self-employed taxpayers to deduct the “employer” portion from their taxable income because an employer would be able to do the same. As a result, they would be able to deduct $3,532 when determining the amount of their taxable income.
This probably won’t affect their marginal rate when she is deciding whether to take the promotion, but the marginal rate for any additional self-employment opportunities he receives will need to be adjusted to factor in the 15.3% self-employment tax.
Additional State Marginal Tax Rates
In addition to the federal marginal tax rates and potential self-employment tax, you will also need to consider your state’s specific marginal tax rate. Some states have no personal income tax, while others have very high personal income tax rates.
For example, in California, marginal income tax rates range from 1% to 13.3%. (2) California also has sales tax of as high as 9.25% in a certain county, but that is for another article.
Taxes stink. There are no two ways to cut it. However, by familiarizing with the tax code (and getting a good tax advisor) you can save yourself a fortune over your lifetime.
If you are interested in finding out more on how life insurance can actually help you create a tax free income stream in retirement, please give us a call today for a complimentary strategy session.