Calculating your taxes probably isn’t your favorite weekend hobby, but it’s still an important skill, even if Tax Day got pushed to June 15, 2020. One important concept you may not be familiar with is marginal tax rates.
What Is a Marginal Tax Rate?
The marginal tax rate is a rate of tax assessed on each additional dollar of income. The United States uses a federal marginal tax rate that increases as income rises. In other words, the more you earn, the more you pay.
The United States implements the marginal tax rate by splitting taxpayers into brackets based on their taxable income. Tax rates increase from bracket to bracket, so you’re not charged a single, static tax percentage of your entire income. Instead, you’re taxed in steps.
Why Marginal Tax Rates Matter
The use of marginal taxation is also known as progressive taxation. Its goal is to tax citizens based on their earnings so that low-income earners aren’t burdened by high rates they can’t afford.
The marginal tax rate has always been a controversial topic; some people believe it offers an equitable method to distribute taxes, while others believe it discourages Americans from working hard to become wealthy.
Of course, marginal tax rates matter because they influence your financial planning as well! You can’t effectively calculate the effects of a raise or the pros and cons of a certain retirement account unless you know how your income is taxed.
How They Impact Your Taxes
The marginal tax rates change with time. Looking ahead to the 2021 season, here’s a breakdown of how your income will be taxed by the IRS: (2020 season is slightly lower)
- 35%, for incomes over $207,350 ($414,700 for married couples filing jointly)
- 32% for incomes over $163,300 ($326,600 for married couples filing jointly)
- 24% for incomes over $85,525 ($171,050 for married couples filing jointly)
- 22% for incomes over $40,125 ($80,250 for married couples filing jointly)
- 12% for incomes over $9,875 ($19,750 for married couples filing jointly)
In other words, the first $9,875 you make as an individual, or the first $19,750 for married couples filing jointly, is charged a 12% tax. The next chunk of your income, up to $40,125, is assessed a 22% tax. This continues up the scale until you hit the top: every dollar you make over $207,350 (or $414,700 for married couples filing jointly) is taxed at a marginal tax rate of 35%.
The marginal tax rate demonstrates exactly why savvy savers use pre-tax investments like employer-matched 401(k) accounts and tax-deductible accounts like traditional IRAs to decrease their amount of taxable income.
If you normally make $250,000 a year, more than $40,000 of your income is hit with a 35% tax rate unless you can claim a lower taxable income after your investments. It’s easy to save tens of thousands of dollars this way!