Marginal vs Effective Tax Rates–What You Need to Know

Several readers have recently emailed me about Roth retirement accounts. The questions that have arisen include the difference between marginal tax rates and effective tax rates. It’s an important topic that we’ll cover in two articles. In this article we’ll walk through the difference between marginal and effective tax rates. In the next article we’ll cover how to use this information when evaluating Roth vs. pre-tax retirement contributions.

Marginal Tax Rate

The marginal tax rate is the amount of tax paid on an additional dollar of income. Add one dollar of taxable income to your return, determine the amount of additional tax you’d pay, and divided that tax by the $1 of income. The result is your marginal tax rate.

Confused? Let’s review. The federal income tax system in the United States is progressive. As a result, not all of your taxable income is taxed at the same rate.

For 2014, for instance, if you’re a single taxpayer, your first $9,075 of income will be taxed at a 10% rate. What you make over $9,075 but under $36,900 gets taxed at 15%. When you go over $36,900, the rate jumps to 25% up until you make $89,350. The rates continue to rise as you make more income. Currently for a single tax payer, those who make $406,750 per year are at the very top bracket. Every dollar they make over that limit will be taxed at the highest rate – 39.6%.

It’s like climbing stairs. The tax brackets are the steps. The more you make, the more steps you have to take. You can see the 2014 federal tax brackets for all filing statuses here.

When most people talk about marginal tax rates, they’re referring to the top tax bracket for their taxable income. For example, a person with taxable income for the year of $1,000,000 would have a marginal rate of 39.6%. So would an individual with taxable income of $425,000. Why? The top bracket applies to all taxable income over the $406,750 for a single taxpayer. An individual with $100,000 in taxable income would fall into the 28% bracket.

Here’s the key. The marginal tax rate does not mean that the entire $100,000 of taxable income is taxed at the 28% rate. The 28% marginal rate in this example is what one would pay on about the last $11,000 you make – the income that’s between $89,350 and $100,000. Are hypothetical taxpayer would still paying 10% for the first $9,075 in taxable income, just like every other taxpayer out there. And she would still pay 15% for income between $9,075 and $39,600, and so on and so forth.

Your marginal tax rate is only the rate that you pay on the last dollar of taxable income that you make.

Beyond Tax Brackets

So far we’ve focused entirely on the tax brackets. The marginal tax rate, however, can be a bit more complicated. Particularly for high income earners, various deductions and credits are phased out as more income is earned. In other words, the value of some deductions and credits are reduced as you make more money.

The purpose of phase outs is to focus the tax benefits on those who make less money. Phase outs are important in calculating your marginal tax rate. for example, if an extra dollar of taxable income reduces a deduction or credit, dish should be considered when determining your marginal rate.

As an example, the benefit of itemized deductions is phased out once taxpayers reach a certain taxable income level. Referred to as the Pease Limitation, after Congressman Donald Pease, this phaseout reduces the benefit of itemized deductions by 3% of each dollar earned over the phaseout limit. The net effect is to increase the marginal tax rates for the top three tax brackets by about 1%.

These phase outs are important. For example, when assessing the benefit of a pretax retirement contribution, your marginal tax rate should account for these phase outs. They have the effect of increasing the tax benefit of the retirement contribution, which can be an important consideration when evaluating whether to contribute to a pretax retirement account or a Roth retirement account.

Effective Tax Rate

The effective tax rate is easier to understand and calculate. It is simply the total income taxes an individual pays divided by their total income. The effective tax rate is generally much lower than an individual’s marginal tax rate.

The effective tax rate calculation serves several purposes. First, it can be helpful to compare your overall taxes from one year to the next. Second, it is useful in comparing overall tax liability between different individuals. This can be important when setting income tax policy.

Blended Tax Rates

Generally, marginal tax rates are used to make financial decisions. For example, one would look to his or her marginal rates in assessing the benefit of a charitable contribution. Likewise, one generally looks to marginal rates in assessing whether to contribute to a pretax retirement account or a Roth retirement account. In making these decisions, however, one must consider more than just the marginal tax rate.

For example, a $15,000 contribution to a pretax 401(k) may result in moving the taxpayer into a lower tax bracket. A single tax filer with approximately $94,000 in taxable income, has a marginal tax rate of 28%. A $15,000 pretax retirement contribution, however, would move them into the 25% tax bracket. Approximately $5,000 of the contribution would save them 28% in federal income tax. The remaining $10,000 contribution would save them 25% in federal income tax. The net effect is a tax savings that is a weighted average between the 28% and 25% tax brackets.

The move from one marginal tax rate to another, as well as the phaseout of deductions and credits, complicates the choice between a pretax and Roth retirement account. On the bright side, it offers some potential for real tax savings. We’ll examine those potential tax savings in the next article in the series.

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2 Responses to “Marginal vs Effective Tax Rates–What You Need to Know”

  1. Chris

    Rob,

    I was given a large signing bonus (20k) that I am supposed to use to move (MO to NC). How can I set up my w-4 at my new job so that I can get the most cash now? Married and have 4 kids. I also have charity (church tithes) i donate too. I have a student loan at 2% interest and will be going from a mortgage to renting.

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