As a CPA, one of the biggest misunderstandings I see when it comes to taxes is the idea of being in a certain tax rate. Every year, I have clients ask me how close they are to the next tax rate so they can avoid it, or what they can do to get themselves in a lower tax rate. I’m all for doing everything legally possible to reduce your taxes, but the surprising truth is that getting yourself into a lower tax rate will have a much smaller impact on your tax liability than you probably think.
Progressive Tax System
In the United States, we have what is called a progressive tax system. This means that as you reach higher income levels, you are moved into higher tax brackets. But contrary to popular belief, the tax bracket you end up in is not the amount your entire income is taxed at. Instead, your income will be taxed at each tax bracket level you pass through. That is a little confusing to read, so let’s look at an example.
Let’s say that in 2012, you were married and your taxable income was exactly $100,000. Here’s how your tax liability would look.
Your first $17,400 of income would be taxed at the lowest rate, 10 percent and result in $1,740 in tax liability.
Your next $53,300 of income would be taxed at the second lowest tax rate, 15 percent and result in $7,995 in tax liability.
And finally, your last $29,300 of income would be taxed at the third lowest tax rate, 25 percent and result in $7,325 in tax liability.
Marginal vs. Effective Tax Rates
In the example above, your $100,000 in taxable income would have resulted in a total tax liability of $17,060. If the tax system worked the way most people thought, simply taxing your income at the rate you fall in, you would have ended up with a tax liability of $25,000 ($100,000 of taxable income at the 25 percent tax rate). The difference between these two is what is known as marginal vs. effective tax rates.
Your marginal tax rate is the rate at which the next taxable dollar you earn will be taxed. Using the example above, a married couple who had $100,000 in taxable income would fall into the 25 percent tax bracket. So the next taxable dollar they earn will be taxed at 25 percent. This will stay the same until they reach $142,700, at which point their next taxable dollar will be taxed at 28 percent.
Your effective tax rate is the actual percent of tax you end up paying on your total taxable income. Again, using the example above, you would have paid $17,060 in tax on $100,000 in taxable income, which means your actual, or effective, tax rate would be about 17 percent.
Is Your Marginal Rate Important
So if your effective tax rate, your actually rate of taxes paid, is significantly less than the tax rate you fall into, does marginal tax rate even matter?
While your marginal rate doesn’t matter near as much as most people think, it is still an important tool when it comes to tax planning. Just because all of your income isn’t taxed at your marginal tax rate doesn’t mean that knowing what your next taxable dollar is taxed at isn’t important. For example, if you expect to make $10,000 more next year than you did this year, knowing your marginal rate may be very important. It will tell us how much more in tax liability you will owe next year.
But overall, knowing which tax bracket you fall into is significantly less important than most people think. The progressive tax rate means that only a small percentage of your income will be taxed at your actual tax rate. Knowing this may save you the trouble of trying to get into a lower tax bracket.