Tax Rate vs. Marginal Tax Rate

Understanding the concept of marginal tax rate can help manage your finances.

Understanding the concept of marginal tax rate can help manage your finances.

Like the taxation authority in most countries, the United Stated Internal Revenue Service enforces a progressive tax rate. In simpler terms, the more money you make, the higher your tax rate. The tax code implements this basic process by using tax brackets, which means that your income is divided into various tranches, with a different tax rate applied to each tranche. Understanding how this system works and what marginal tax rate means is critical for any taxpayer.

Tax Brackets

When calculating your tax liability, first compute your taxable net income and then divide the resulting figure into tax brackets. A tax bracket is simply a method of dividing your income into various slices, with each progressive slice subject to a higher rate. Tax brackets work in this way: Of two tax brackets that respectively apply to the portion of your income below $10,000 and above $10,000, at an associated tax rate of 10 and 20 percent, respectively, if you earn $30,000, you have $10,000 in bracket 1 and $20,000 in bracket 2.

Additional Examples

Think of tax brackets as buckets, which you must respectively fill with your income. In the prior example, the first bucket can hold $10,000 worth of income, while the second holds an infinite amount -- because there is no third bracket and everything that doesn't fit into the first bucket must go into the second. With $30,000, you will fill up the entire first bucket and pour the remaining $20,000 into the second one. If you made only $7,000, it would all fit into the first bucket with nothing left for bucket two. Spanning three brackets, applied to income up to $10,000; between $10,000 and $40,000; and above $40,000, for $55,00 of taxable income, the division would be as follows. You would use up all of bracket one and two, in which you have $10,000 and $30,000, respectively, adding up to $40,000. The remaining $15,000 of your income then goes into bracket three.

Effective Rate

Assume that the tax rates that apply to the three brackets in our last example are respectively 10, 20 and 30 percent. You would pay 10 percent of $10,000 plus 20 percent of $30,000 plus 30 percent of $15,000. In total, you would pay $11,500 in taxes. Since your total income was $55,000 and your tax bill $11,500, the effective tax rate equals $11,500 divided by $55,000 multiplied by 100, or 20.9 percent. This is your effective tax rate, since you paid 20.9 percent of your income to the taxman.

Marginal Rate

Although your effective tax rate is 20.9 percent, your marginal tax rate is 30 percent in our example. The marginal rate is the rate that applies to the final tax bracket. This figure matters because additional income is taxed at the marginal rate. If, for example, you anticipate that you will make $55,000 for the year from your current job and could make an extra $10,000 from overtime, that additional $10,000 will all go into the last, highest tax bracket, to be taxed at 30 percent. You will pay $3,000 of this extra $10,000 in taxes and take home an extra $7,000 as a result of overtime.

About the Author

Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.

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