How marginal tax rates work
Yesterday I hosted a guest article about the mortagage-interest tax deduction. As part of his argument that this tax break should not be used to justify buying a house, CJ from Wise Money Matters looked at the savings by tax brackets. What CJ did not consider (and what escaped my notice, and even that of my accountant) was the concept of marginal tax rates.
Although I was mortified to have let such a blatant error pass through editing, I decided to turn this mistake into a positive experience. I spent some time reading about marginal tax rates, and today I'm going to share what I learned.
Marginal Tax Rates
Let's start by looking at the 2009 U.S. federal income tax brackets for ordinary income. (These are the rates we'll use when filing our tax returns in 2010.) For the sake of simplicity, we'll only examine the rates for single filers and for those who are married filing jointly. The same principle applies to all filers.
Gillian's income is actually taxed progressively, at each bracket up to her marginal rate. Does that sound like gibberish? It's actually not so bad. Using the example above:
- The first $8,350 of Gillian's $100,000 income would be taxed at 10%, for a total of $835 in taxes due.
- The next $25,600 of her income would be taxed at 15%, for a total of $3,840.
- The next $48,300 of her income would be taxed at 25%, for a total of $12,075.
- The final $17,750 of her income would be taxed at 28%, for a total of $4,970.
Because Gillian earns $100,000 of taxable income, she is said to be in the 28% tax bracket. That's the percentage she's taxed on the last dollar she earns. But most of her dollars are taxed at a lower rate. In fact, as a single filer earning $100,000 in taxable income, she'll owe $21,720 in taxes for 2009, which means her effective tax rate will be 21.72% — not 28%.
An Easy Mistake to Make
CJ's article yesterday originally contained a mistaken analysis of the mortgage interest tax deduction. He was applying marginal rates as if they were effective rates. I did not catch it, and neither did my accountant. I'm well aware of marginal rates (and so, obviously, is my accountant), which demonstrates just how confusing this can be — if you don't pay attention.
Even large media outlets make mistakes with marginal rates. President Obama's tax proposal would increase taxes on families earning more than $250,000 per year. ABC News ran a story profiling upper-income taxpayers who are looking for ways to sidestep this tax hike. One of them, a 63-year-old attorney from Louisiana, is quoted in the article:
“We are going to try to figure out how to make our income $249,999.00,” she said.
“We have to find a way out there we can make just what we need to just under the line so we can benefit from Obama's tax plan,” she added. “Why kill yourself working if you're going to give it all way to people who aren't working so hard?”
Before ABC News revised the article (just as I revised the error out of yesterday's story at Get Rich Slowly), its main thrust was grounded firmly on a misunderstanding of marginal and effective tax rates. But this attorney is working from a false premise. If she makes $250,000 per year, she's only going to pay a few cents more in taxes than if she earns $249,999 per year.
My point here isn't that the attorney is dumb or that the reporter is dumb or that CJ is dumb or that my accountant is dumb or that I am dumb. My point is that marginal tax rates can be confusing, even for those who know better. When you speak about tax rates and tax brackets, always take a moment to be clear whether you're speaking about marginal tax rates or effective tax rates.
Then you can avoid posting blog articles (or news stories) that contain embarrassing errors!