Marginal tax brackets are a frequently misunderstood topic. It’s not uncommon for someone to say they don’t want to get a raise because it will put them in a higher tax bracket and force them to pay more taxes on all the money they earn. They believe they would be better off not receiving the raise in the first place. Thankfully, that is not how marginal tax rates work.
For example, let’s say you receive a salary increase that takes your final salary from the 15% tax bracket to the 25% tax bracket. Your raise expose all of your income to the 25% tax bracket. You only pay the higher taxes on the amount that falls within the 25% tax bracket. We’ll show you the income levels for each tax bracket and show some examples of how the tax actually work.
Understanding Marginal Tax Rates
This “gradual” tax schedule is called a marginal tax rate system. In effect, the amount of taxes you pay rises as your income rises. The IRS places the marginal tax rates into brackets, making the marginal tax formula easier to understand and compute by hand. Let’s look at the 2017 Federal Tax Brackets to see this in action.
2017 Federal Income Tax Brackets
|Marginal Income Tax Brackets||Single||Married Filing Jointly||Head of Household|
|10% Tax Bracket||$0 – $9,325||$0 – $18,650||$0 – $13,350|
|15% Tax Bracket||$9,325 – $37,950||$18,650 – $75,900||$13,500 – $50,800|
|25% Tax Bracket||$37,950 – $91,900||$75,900 – $153,100||$50,800 – $131,200|
|28% Tax Bracket||$91,900 – $191,650||$153,100 – $233,350||$131,200 – $212,500|
|33% Tax Bracket||$191,650 – $416,700||$233,350 – $416,700||$212,500 – $416,700|
|35% Tax Bracket||$416,700 – $418,400||$416,700 – $470,700||$416,700 – $444,500|
|39.6% Tax Bracket||$414,401 +||$470,701 +||$470,701 +|
Applying Federal Tax Rates to Your Situation
As you can see from the above federal tax bracket table, there are tax brackets for income ranges. For example, a married couple will pay the following taxes:
- 10% federal income tax on the first $18,650 of income;
- 15% federal income tax on income from $18,650 – $75,900;
- 25% federal income tax on income from $75,900 – $153,100;
- and so on.
This is a gradual tax system, and does not mean that you will pay the corresponding income tax rate if you break the threshold by $1. For example, receiving a raise from $70,000 to $70,701 will not subject all of your income to the 25% tax bracket – it will only apply to income earned within that range. These gradual tax rates add up to your effective tax rate.
How to Your Calculate Effective Tax Rate
Let’s use an example of a married couple filing jointly with $100,000 of taxable income (after deductions, exemptions, etc.). They are in the 25% tax bracket, but don’t actually pay $25,000 in federal taxes. They would pay:
- 10% on first $18,650 of income ($1,865)
- 15% on income from $18,650 – $75,900 ($8,587.50)
- 25% on income from $75,900 – $153,100 ($6,025.00)
- for a total of $16,477.50
In this example, the weighted, or effective tax bracket, is 16.48% (note this is effective federal tax only, and does not include state or local taxes. You should be able to find a state tax calculator to assist your calculations). This is easy to figure out when you file your taxes, and most tax software programs, including TurboTax and H&R Block (H&R Block Online Review), can give you these calculations when you use their program.
Using Marginal Tax Rates for Tax Planning
Using your knowledge of the marginal tax rate system, you can use them to help reduce your taxes if you are near one of the tax bracket limits. All you need to do is bring your final number below the tax bracket. For example, if you are married filing jointly and earn $77,900, you can contribute $2,000 to your 401k and avoid paying the higher tax rate on $2,000. The tax savings can easily add up to a couple hundred dollars to several thousand, depending on how much you can shave from your marginal tax rate.