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Slight Misunderstanding of Marginal Tax Brackets

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Reader Ann asked the following question on my post about the 2008 Federal Income Tax Brackets:

Jim ~

My husband has just been offered a salaried position of which he is excited yet somewhat reluctant about. The increase in salary would put us “over the edge,” so to speak, into the 25% tax bracket. His position probably doesn’t have much more room for increased income. We are not currently in a position to owe significantly more tax. In addition, we are quickly loosing our child deduction as they are becoming “independent.” Advice?

Here was my reply:

Hi Ann,
I think you may be misunderstanding how the tax brackets work, the listed rate only applies to dollars that exceed the low end of that tier. Your entire salary isn’t being taxed at the bracket rate. I think this is best explained using an example.

Let’s say for the sake of argument your husband earns $60,000 a year, which puts him in the 15% tax bracket at the moment. The new job has a salary of $66,000 a year, which is above the start of the 25% tax bracket of $65,100 (for married filing jointly). Only $900 of his new salary (the amount above $65,100) is taxed at 25%, not the whole $66,000.

In fact, if you were to take the standard deduction for married filing jointly of $10,900 then your income would be reduced to $55,100 and not a single dollar would be taxed at 25%. Further deductions could pull you further down the list on your marginal tax rate.

Unless I’m misunderstanding your question, I think you just had a mixup in thinking how the brackets worked.

This is a mistake many people often make when they learn about the progressive tax system. They think that “tax rate,” despite being called a marginal tax rate (thought marginal has a specific meaning not often used in conversational English), is applied to your entire income. That rate is only applied to your next dollar earned. For the 25% tax bracket, for single filers, starts at $32,550 and ends with $78,850 – you are only taxed 25% on the 32550th dollar you earn p to the 78849th dollar you earn.

In reality though, it’s even less than that because with deductions and credits, your effective tax rate is far far less. Right off the bat, single filers can claim a standard deduction that reduces their income by $5,450. If you work and contribute to a 401(k) plan, each dollar you contribute is deducted off your taxes. At the end of the year, you’ll find that your actual adjusted income is far lower than your salary, so your effective tax rate is much lower than even the aggregate of the tax brackets.

{ 15 comments, please add your thoughts now! }

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15 Responses to “Slight Misunderstanding of Marginal Tax Brackets”

  1. Start-Up says:

    I’ve never taken the time to figure out if my entire income is taxed at the new rate or just the income above the plateau. Now I don’t have to.

    Did you mean you are only taxed 25% on the 32550th dollar you earn up to the 78849th dollar you earn instead of:

    “you are only taxed 25% on the 32550th dollar you earn p to the 32549th dollar you earn”

    ??

    I’m assuming so, but just clarifying

  2. Ben says:

    Hear, hear. Though the confusion is based off of the old tax code from the first Bush presidency and before (I think). But now it’s changed to what you described it.

    Your AGI (adjusted gross income) is what the tax is ultimately based off of. Although if you end up like me with too many deductions (close to 25% of income) you get stuck with AMT which is actually why I lowered my 401k contributions this year.

  3. jim says:

    Start-Up: Yeah I did… Cut and Paste failed me.

    Ben: No, it’s been that way for a long time.

  4. Lord says:

    No, it was always like this, it is just that the brackets weren’t indexed originally so inflation would result in more taxes. I believe median average tax rates are just under 20%.

  5. Jim says:

    Good post Jim. This is a topic that a lot of people are confused about. I used to be confused about it too. I had a post about this myself not long ago and I made a graph showing the EFFECTIVE tax rates as your income goes up. See:
    http://freeby50.blogspot.com/2008/08/how-do-tax-brackets-work.html

    Another thing you can do is look through the tax tables in the 1040 instruction book. You can see that the numbers go up gradually. Theres no large jumps in taxes due to entering a new marginal tax bracket.

    Lord, The median is around 10% and the average is around 12%

    Median household income is about $50k. Federal income taxes are around 10% effective that much.

    Average effective federal income tax rate for all tax payers is around 12% (its skewed higher due to the very high income earners). But the bottom 50% of tax payers pay only about 3% average taxes to the IRS while the top 50% of us pay over 13% tax.
    See: http://www.taxfoundation.org/publications/show/250.html

    Jim

  6. Todd A. says:

    Great post. It wasn’t all that long ago that I misunderstood the concept of marginal tax brackets. Probably a hundred other tax terms/concepts I still don’t know ! ;-)

  7. JB says:

    An easy way to figure out a close approximation of your effective tax bracket is to look at your paycheck, divide your Net Pay (the amount that gets deposited in the bank) by your Gross Pay (the amount at the top, before taxes are taken out). (this works as long as you were correct on your W-4 and aren’t itemizing).

    For example, I just did mine: I make $65k a year, and am in the 25% bracket:

    -16.9% Federal
    -7.5% Payroll Taxes (FICA)
    -7.2% Maryland State Tax

    Total Tax Burden: 31.6%

    …ouch!

  8. Great post, this is something that seems to be very widely misunderstood. I even remember my favorite high school math teacher complaining with this very misconception!

  9. MoneyBeagle says:

    This is a great article. The accountant that does our taxes gives us a summary sheet every year, and two of the lines pertain to the tax rate. One is the ‘marginal’ bracket and the other is the ‘actual’ percent of tax paid. This makes it easy to see. I wish more people understood this, thanks for pointing it out in an easy to understand way.

  10. saladdin says:

    What drives me crazy is people that turn down higher paying positions because they will end up in a “higher” tax bracket. My best friend’s wife did this. I tried to explain taxes to her but it did not help. She turned down a higher paying job to keep from paying more taxes.

    saladdin

  11. Walt Bauer says:

    To add confusion, there is the “actual” marginal rate. To understand it just add $100 to an income source say interest and recalculate the new tax. For some senior citizens on SS the tax bracket may be 15 % but the actual additional tax dollars required to cover the $100 extra income is $27.75 or 85% more. It’s the way the IRS penalizes old folk for saving.

  12. Emily says:

    But what does this mean when it comes to the AMT (Alternative Minimum Tax)? If you go over the AMT limit, it can mean making less, doesn’t it? I’m always confused about this issue. Luckily, my husband and I are still just below it, but I’m always very concerned about what’s going on with that, because my husband always seems to be just one raise under it and congress is only barely keeping up.

  13. eldergal says:

    I have to say, this is extremely helpful! I was worried, as my husband started a new job with a very generous salary (we’re both recently finished college), and I saw that it would bump us into the next tax bracket. Given this is his first year working, I was afraid we would owe some massive sum to the IRS come April. Now that I better understand it, I can look through things again. Knowing this now, I think we’ll be OK!

  14. Art says:

    Jim Wang’s article is not a complete and accurate treatment of the marginal rate situation in federal income tax calculations.

    It is apparent from the comments that most taxpayers fail to grasp even the basics of marginal calculations. How is the average taxpayer ever to understand the complications introduced through the nuances of phase-ins/phase-outs of deductions, exemptions, and credits, and the interplay with marginal brackets?

  15. T-L Yang says:

    My wife and I did significant amount of covertion from IRA to Roth IRA in 2010. Is the converted total amount added to our total income and treaded as additional earned income? This will take the total income into the 35% marginal tax bracket. Do we effectively owe 35% of the converted amount?


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