Understanding Marginal Tax Rates
Many of your financial decisions require a basic understanding of how income taxes work.
Marginal tax rate is the tax rate you pay on any changes in income.
Your marginal tax rate is a key input into many different financial decisions. In particular, it's important in your decisions about traditional tax-advantaged savings accounts such as IRAs and 401(k)s due to their effect of deferring income taxes until retirement, as well as the decision to invest in tax-advantaged but lower-yielding municipal bonds in taxable accounts.
As financial advisors, it's important to have a basic understanding of the tax situation for each of our clients. Most of the time, the most important piece of information we need is your marginal tax rate. We frequently find that clients don't know their marginal tax rate and don't know how to figure it out; this article is a deep dive into the relevant parts of the tax code so you can see how we estimate marginal tax rates for our clients.
In brief, we have a six-step process for the calculation:
We use a federal tax table and your state's tax table to look up your tax bracket, and add them together to get an estimate.
Depending on the situation, we may also add your FICA (Social Security and Medicare) tax rate to the estimate.
If you are currently receiving Social Security benefits, we look at your most recent tax filing to see if you're affected by the "phase-in" of taxing these benefits.
We look at your most recent tax filing to see if you are taking any tax credits that phase out, and adjust our estimate based on the effects of those tax credits.
We check your gains on investments to see if you'll be affected by a special quirk of the tax code due to how capital gains are taxed.
We examine any benefit programs that our client is using to determine if the benefit gradually phases out.
If you haven't yet read the first article in our series about tax and investing, a basic understanding of its contents would be helpful here. We'll discuss in more detail how this process works, but first let's discuss the difference between effective and marginal tax rates.
Effective versus Marginal Tax Rates
Effective tax rate is the tax rate you pay on all your income. If you earned $50,000 last year and paid $5000 in income tax, your effective income tax rate is 10%—you paid 10% of your total income in taxes.
This is not the same thing as your marginal tax rate! Marginal tax rates apply to changes in income. Think of this as the tax rate that applies to the raise you got at work, or the bonus you got at the end of the year. (Remember that in the US, federal income tax (as well as many states' income tax) is a graduated tax system: there are tax brackets so that low earners pay income tax at lower rates than high earners. For a refresher, please review our "Demystifying US Income Tax" article.)
Let's look at an example to help explain. Consider a married couple who earned $60,000 in 2020. They would pay:
No tax on the first $24,800 in income (due to the standard deduction)
10% tax on the next $19,750 in income, or $1975
12% tax on the remaining $15,450 of their income, or $1854
Their total federal income tax would be $3829, making their effective tax rate about 6.4% ($3829 divided by $60,000).
Now let's assume this tax filer got a $1000 bonus at the end of the year. All of the bonus would be in the 12% tax bracket, so they would pay an extra $120 in federal income tax. Their marginal federal income tax rate would be 12%.
Withholding (A Tangent)
If you've ever gotten a bonus at the end of the year and wondered why so much gets taken out due to withholding, it's because of the difference between marginal and effective tax rates.
On your regular paycheck, the withholding system tries to deduct at approximately your effective tax rate. If the system estimates that you'll have an 8.6% effective tax rate when you file your income tax return, it'll withhold about 8.6%. (It's not an exact science, which is why you need to file an income tax return every year to reconcile the withholding estimate with your actual tax owed.) When you get a bonus, the withholding system tries to deduct at approximately your marginal tax rate. A bonus is a change in income, so the marginal tax rate is a more accurate estimate for the purpose of withholding.
What's My Marginal Tax Rate? A Rule of Thumb
For most tax filers, there's an easy process to estimate your marginal tax rate. Remember that there are usually three components to the tax you pay on your income:
Federal income tax
State income tax
"FICA" (Social Security and Medicare contributions under the Federal Insurance Contributions Act)
Your marginal tax rate is generally equal to the sum of the marginal rates on each of these components. (This should make sense intuitively: if you get a bonus of $1000, you'll end up paying federal income tax at the marginal rate, state income tax at the marginal rate, and FICA at the marginal rate.) Fortunately, it's simple to find the marginal rate for each of these components.
Federal Income Tax Marginal Rates
Federal income tax rates are probably the most well-known, and should be familiar if you've ever looked up your tax bracket in a table like this:
The rates in tables like this are the marginal tax rates. (This contributes to the confusion between marginal and effective tax rates: remember that your marginal tax rate may be 24%, but that doesn't mean you pay 24% of your income in federal tax! Your effective tax rate is almost always lower.)
To find your marginal tax rate in a table like this:
Start with your total income.
Subtract your deductions to find your taxable income. For most people, the standard deduction in 2020 is $12,400 for single filers or $24,800 for married filers.
Look up the resulting amount in the tax table.
State Income Tax Marginal Rates
Of the states that have an income tax, most use a system that's similar to federal income tax. There's usually a standard deduction which means some of your income is exempt from state tax, and then one or more tax brackets that applies different tax rates to different chunks of your income. This means that the procedure for finding your state income tax marginal rate is generally similar to finding your federal marginal income tax rate:
Start with your total income.
Subtract your deductions to find your taxable income.
Look up the resulting amount in the tax table.
There isn't enough space here to reproduce tax tables for all the states that have income tax; your state's Department of Revenue (or equivalent) is usually the best resource, or you can check the Tax Foundation's web site at taxfoundation.org.
FICA Marginal Rates
This is usually the easiest rate to calculate. Social Security tax takes 6.2% out of your paychecks for every dollar up to the limit, which is $137,700 as of 2020. (Note that the standard deduction from income taxes doesn't apply here!) Medicare tax takes 1.45% out of your paychecks, but there's no cap. This means your FICA tax marginal rate is either 7.65% if you earn less than the Social Security limit, or 1.45% if you earn more.
There is a twist, however, for independent contractors and self-employed workers. Your employer is also required to pay FICA tax at the same rates: if you pay 7.65% of your paycheck, your employer must pay the same amount extra. If you're self-employed, you have to pay this portion of the FICA tax as well. You'll end up paying a marginal tax rate of about 15.3% if you earn less than the Social Security limit, or 2.9% if you earn more.
Be careful when including this in your estimate, because the FICA tax doesn't always affect your marginal tax rate. For example, consider contributions to a pre-tax retirement savings account like a traditional IRA or 401(k). For these accounts, you can divert money from your paycheck into the retirement savings account and you generally don't have to pay income tax on it right away. (For these accounts, withdrawals are treated as income so you'll pay income tax in your retirement years.) However, FICA tax is not "delayed" and still applies to the amounts you contribute. Therefore, your marginal tax savings for contributions to these accounts is just what you save on federal and state income tax.
Let's look at a married couple who live in Illinois and earn $60,000.
Federal income tax marginal rate: 12% (from the table)
State income tax marginal rate: 4.95% (from the Tax Foundation)
FICA marginal rate: 7.65%
A good estimate of this couple's marginal rate is the total of these three rates, or 24.6%.
Fine-Tuning the Estimate
There are some times when your marginal tax rate will be different from the rule of thumb above. It can be helpful to have a financial advisor who will be able to apply some of these nuances to your particular circumstances.
Social Security "Phase-In"
If you are receiving Social Security benefits, not all of the benefit is taxable. The calculation to determine how much of your benefit is taxable is not at all straightforward, but the effect of it is. In general, the phase-in of taxing your Social Security benefits will increase your marginal tax rate by either 50% or 85%, depending on the particulars of your situation. (Note that the increase is a percent, not percentage points. If your estimated marginal tax rate is 10%, the effect of Social Security on your marginal rate will raise it to either 15% or 18.5%.)
The phase-in starts at about $25,000 in income for single tax filers and about $32,000 for married tax filers. The phase-out ends at the point where 85% of your Social Security benefits are taxable, which varies depending on the amount of your benefits and other income.
Tax Credit "Phase Out"
Some tax credits that "phase out" can affect your marginal tax rate. Remember that tax credits are reductions in the tax you owe that are a result of specific decisions you make or the specifics of your personal circumstances. Here are a few of the most common ones on the federal income tax return, although there are many others not listed here:
Child tax credit/credit for other dependents: a credit that reduces your tax based on your number of qualifying children or other dependents
Earned income tax credit: a fully refundable credit for low-income filers that can be worth up to around $6500, depending on family size
Retirement contributions savings credit: a tax reduction of up to $1000 per person for contributions to a retirement account
American Opportunity Tax Credit/Lifetime Learning Credit: tax reductions for higher education expenses
Health insurance premium tax credit: a credit for low-to-moderate income earners who purchase health insurance through the Affordable Care Act marketplace
Each of these tax credits phases out over a certain income range. For example, you'll get the full value of the child tax credit if you are single and your taxable income is no more than $200,000, or if you're married and your taxable income is no more than $400,000. The tax credit gradually phases out as you earn additional income beyond these limits: your combined child tax credit drops by $50 for every additional $1000 you earn. This means that if your income is in this "phase out" zone, your marginal tax rate is 5 percentage points ($50 divided by $1000) higher than the estimate from the "rule of thumb" calculation.
While we won't discuss every phased-out tax credit in this article, here are some common ones and the "phase out" income ranges. A qualified tax professional can help you understand the effects of each of these on your marginal tax rate.
Outside of these "phase out" areas, tax credits generally affect your effective tax rate but not your marginal tax rate. Please consult a CPA or other qualified tax professional for advice specific to your situation.
Capital Gains Tax "Bump Zone"
There is a quirk in the way capital gains tax is calculated that can result in higher marginal tax rates. Recall the "income stack" from our "Understanding US Income Tax" article:
In the example above, this tax filer's capital gains portion of the income stack straddles two different capital gains brackets. Remember that since capital gains dollars are at the top of the stack on top of any earned income, additional earned income dollars "push" capital gains dollars up. In this example, if the tax filer got a $100 bonus, he or she would pay an additional 24% in federal income tax. However, there would also be room for $100 less in capital gains dollars to be taxed at 15%. These dollars would instead be taxed at $18.8%, a rate 3.8% higher. This tax filer's effective marginal federal income tax rate would be 27.8%.
This effect only happens when realized capital gains straddle between two different brackets, so it occurs when your taxable income is just under these bracket thresholds.
Finally, many benefit programs intended for low-income households phase out their benefits based on income. Various studies have examined the impact of these programs and found that low-income households in the United States can face effective marginal tax rates of around 70-80%, due to a combination of paying federal and state income taxes, FICA, and losing benefits from multiple different programs as their incomes rise.
As each program has a different income threshold, please consult a qualified financial advisor or tax professional for assistance about your particular situation.
All information provided in this article is for informational purposes only and is not intended to provide investment or tax advice. Opinions expressed are those of CJW Capital LLC (CJW Capital) as of the date of publication and are subject to change at any time due to changes in federal, state, and local tax codes. While efforts are made to ensure information contained herein is accurate, CJW Capital cannot guarantee the accuracy of all such information presented. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by CJW Capital to be reliable and are not necessarily all inclusive. Reliance upon information in this material is at the sole discretion of the reader. Material contained in this publication should not be construed as legal, accounting, or tax advice.