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.

You can also view the 2010 federal income tax brackets and a discussion on 2011 federal income tax rates.
Based on this table, if Gillian is single and has taxable income of $100,000 in 2009, her marginal tax rate will be 28%. This does not mean that all of her income is taxed at 28%. She will not owe $28,000 in taxes. Only the top portion of her income is taxed at the highest level.

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!

More about...Taxes

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ObliviousInvestor
ObliviousInvestor
11 years ago

Can I add a tax terminology pet peeve of mine?

Don’t say “tax return” when you mean “tax refund.” 🙂

Eric
Eric
11 years ago

I was always wondering why people got so much up in arms about the proposed tax hike on income over $250k/yr when they made right around that income level. I wonder how many people really don’t understand this concept.

Frank
Frank
11 years ago

From the quote, it’s clear the Louisiana lawyer is exaggerating for effect. But what he (she?) is saying is perfectly logical: if the marginal tax rate above 250K is high enough, it’s not worth the effort to make the marginal dollar.

B
B
11 years ago

So, the real question is whether there is an effect on the substantive conclusions of the article because of the numerical mistake?

Kevin
Kevin
11 years ago

“Gillian’s income is actually taxed progressively”

I may have my terminology backwards, but isn’t this type of tax system actually called “regressive,” and not “progressive?”

Wise Money Matters
Wise Money Matters
11 years ago

Thanks for the clarification. This also does put a huge perspective on Obama’s tax changes that he talked about during his election. One of my big problems with it was the idea that he was going to significantly tax people for going up a tax bracket. I honestly don’t have a problem with increasing the higher marginal tax brackets as I feel anyone who makes $250,000 is likely doing just fine and therefore can handle a slightly higher tax on their highest portion of income (as opposed to their total income).

plonkee
plonkee
11 years ago

@Eric:
I suspect that lots of people don’t understand this, or at least don’t understand it well enough to realise the implications of changes to tax brackets and rates.

@Kevin:
It’s called progressive taxation when you are taxed at a higher percentage when you make more money. If the tax brackets were reversed (35% on the first $8k, 33% between $8k and $33k, 28% between $33k and $82k etc) then that would be regressive.

Regressive taxation is usually considered unfair, because those on lower incomes can usually least afford to pay more in both $ and % terms.

Neal Frankle
Neal Frankle
11 years ago

The marginal tax rate is critically important in helping you make the right decision about investing and taking out a mortgage.

Politically, its also important but from a different perspective. Without question, as marginal rates go up, the incentive to work drops.

I believe that is true – even if the hit is not across the board, its still a disincentive.

Joe
Joe
11 years ago

I have a few things to point out. First, the increase in marginal rates is not the only issue with Obama’s plan. There are other tax credits, deductions, and the like that will be phased out once your income goes above the threshhold. For example, the mortgage interest deduction and the charitable giving deduction. Second, you are correct that marginal rates are important to consider, but deductions benefit you at your marginal rate. In your example, if Gillian pays $15,000 in mortgage interest and that is her only deduction the benefit to her is a $4,200 reduction in her tax… Read more »

Massey
Massey
11 years ago

To Kevin: JD has it correct, in that when higher incomes are taxed at marginally higher rates then that is a progressive tax system. Alternatively, if the working mother of three with an income of $45,000 paid the same marginal/effective rate (in the case of a flat tax they are the same) that Warren Buffet did, then that would be a regressive tax. The idea being that because of the diminishing marginal utility of goods (here money), it is appropriate from an economics perspective to tax lower brackets of income at lower marginal rates. Or in other words, a dollar… Read more »

Charles
Charles
11 years ago

@ Kevin:

Regressive would mean that each tax bracket is taxed a lower percentage than the bracket below it. The goal (in theory) of regressive taxes would be that everyone pays the same amount, rather than the same percentage. The IRS tax code is progressive.

Eric
Eric
11 years ago

It’s also worth pointing out that the tax brackets apply to what the feds call MAGI – modified adjusted gross income. Basically, your net income minus all your deductions. A person who takes home $100k/yr in net income might have a MAGI of $80k.

You have to remember to take deductions into account when you’re trying to figure what your marginal tax rate is. Everybody gets at least the standard deduction, which I believe is $10,900 for 2009.

Jeff@StretchyDollar
11 years ago

Thanks for clarifying. I’d had this explained to me once before, but this explanation makes quite a bit more sense.

ClaireTN
ClaireTN
11 years ago

Wouldn’t her effective tax rate be lower than 21.75% because of deductions and exemptions? The first $5700 of her income would be tax free if she files with the standard deduction (more if she itemizes). Then another $3600 is tax free for her personal exemption. Right? That should bring her effective tax rate down to about 19%.

Holly
Holly
11 years ago

Thanks, J.D., for this very informative post…I also wonder how many just don’t understand this rather basic (and important) distinction. So why, then, does practically every person I know, including those who consider themselves extremely financially literate, raise such a stink when you earn a raise or take on a second job and say, “BE CAREFUL…this could send you into the next tax bracket!”???

Anelly
Anelly
11 years ago

Calculating taxes and rates will definitely give someones headaches at one moment.

Andrew
Andrew
11 years ago

“Alternatively, if the working mother of three with an income of $45,000 paid the same marginal/effective rate (in the case of a flat tax they are the same) that Warren Buffet did, then that would be a regressive tax.” Sorry, no. You are wrong. If everyone pays the same effective rate that’s a FLAT tax, NOT a regressive tax. A regressive tax is when you pay a HIGHER effective rate on a LOWER income. Sales tax is an example of a regressive tax. Also, J.D., it’s not really erroneous to assume the mortgage tax deduction applies to your highest marginal… Read more »

Jeremy
Jeremy
11 years ago

One of my relatives is still confused about this after I’ve told him a thousand times how taxes work. In fact, they refuse to even keep much money in interest bearing bank accounts because he’s afraid the interest earned will push him into the next tax rate and will suddenly owe a higher tax rate on all income.

Ugh, oh well.

Andrea
Andrea
11 years ago

Off topic but there is an AP story today about “extreme frugality”. One of the lines is that the woman’s 2 year old and 3 year old wear hand-me-downs. THIS is what the media think is extreme frugality??? I wear hand-me-downs(from my mom), hand-me-ups(from my grown kids) and hand-me-acrosses(from friends)- and I am 55. And the woman shops with coupons and looks for 70% off sales(heck, wait for the 80% or 90%- and use a coupon).

ryan
ryan
11 years ago

Let me add a couple things to yesterday’s discussion about the mortgage tax deduction. If it’s wrong to post that here, J.D. can remove it. I agree with the premise of the article. We’re prepaying our mortgage–aggressively–and the 30 years will be reduced to 10, or hopefully even less. We could reduce it to a 15 year rate, but there’s just not that much of a difference in the interest rates to justify the higher minimum payments (i.e., the lower minimum payments of the 30 year amortization allows me to have a somewhat lower emergency fund) But that’s our only… Read more »

Stephanie
Stephanie
11 years ago

This is one of my pet peeves, “I quit the job because it put us in a higher tax bracket. We would be paying more in tax than I was making.” Um, no.

Michael Neumann
Michael Neumann
11 years ago

Basically here the issue is the same, do NOT buy a home for the tax write off, do NOT buy a home until you are financially, emotionally, and physically ready to. Getting back to the “tax write off” of your mortgage interest, even if you were to get back 50% of your interest it is not a good deal. Better put, give me as much money as you can every day, and I will give you 50 cents of every dollar you give me. Doesn’t make sense does it? Remember there is alot more to buying a home than the… Read more »

Curt
Curt
11 years ago

That is great. But if you were already more than half way paid off on your original mortgage, then maybe you should have just focued on paying it off within the next few years and savings the money you spend on closing costs.

Dave
Dave
11 years ago

I read yesterday’s post and skimmed over the tax rate issue without a second thought of its accuracy. Perhaps it’s because my taxes are calculated automatically by software since my 2006 returns were filed and I don’t physically go through each tax level with a calculator anymore. Perhaps that’s why others struggle with understanding marginal vs. effective tax rates. If your accountant hands you a completed tax return that only requires your signature (or not even that if you e-file) do you go back through the tax tables to see how the tax was calculated? Being removed from the actual… Read more »

Linear Girl
Linear Girl
11 years ago

Using the marginal tax rate is actually correct when figuring out how much you’ll save from deductions, at least until you’ve got enough deductions to reduce your AGI to the next lower tax rate. Using the effective tax rate would give you an inaccurate assessment. An example: A married couple together earned $150,000 in 2008. Their income between $131,450 and $150,000 ($18,550) is taxed at 28%. Any deductions to their income up to $18,550 come directly out of the money they’re taxed at the 28% rate. Any deductions beyond $18,550 will come off the money they’re taxed at the 25%… Read more »

ryan
ryan
11 years ago

@Andrea #19
Haha, I agree with you completely. There was something in the New York Times the other day, a similar type article. It mentioned something about what the Obama girls wore to the Inauguration. It said they wore J.Crew outfits rather than “designer labels.”
I re-read it twice, thinking I missed something. I thought J.Crew was designer. I guess I’m poorer than I thought. haha

Michael Neumann
Michael Neumann
11 years ago

Just a note on standard deductions for tax year 2009,
single will be 5700
married will be 11,400
more info at taxes.about.com

Camille@TheFinancialWoman.com
11 years ago

One point that I feel is being omitted is that the gain from the sale of a primary residence up to $500,000 for couples (with some conditions, of course.it is the IRS!) is tax free as long as the home was owned and lived in as their primary residence for 2 of the past 5 years prior to the sale. This is important when viewing home ownership from a long term perspective. While it seems right now there will never be gains again in real estate, there will be. Normal will eventually return. As the article points out, there may… Read more »

Massey
Massey
11 years ago

Andrew, I would agree with you whole heartedly that sales tax is a regressive tax because they are paying a flat tax based on the cost of good, which would then equate to people with lower incomes paying higher effective tax rates. And I would further agree that “A regressive tax is when you pay a HIGHER effective rate on a LOWER income.” Well said. But my point about a flat income tax being regressive is that asking people with vastly different incomes to pay the same effective rate is not equitable from a utility perspective. Therefore, I would argue… Read more »

Don
Don
11 years ago

Now that you understand marginal tax brackets a bit better, I recommend you take this to the next level and consider tax rules that “phase out.” The phase out region of any tax rule is an area of even higher marginal rates. From my own taxes for example: my wife receives disability income. Normally our income falls in the 15% marginal bracket because we make between $16050 and $65100 of taxable income. But because of the way tax is computed on disability income, she doesn’t pay tax on all of her income. In fact, if our AGI is $44000 or… Read more »

Shara
Shara
11 years ago

I would like to expand on what Joe said. Taxes aren’t as simple as marginal rates. There are magic points along the income scale that phase out deductions and tax credits, increasing your effective tax rate. For example: for every $1000 you make above $110k (MFJ) you lose $50 of one of the child credits. That increases your effective rate on that money by 5%. There are also phase outs of deductability for student loan interest. And then there is the dreaded AMT (Alternative Minimum Tax) that completely changes everything when you cross a magic threshold. I am working part… Read more »

Jimbo
Jimbo
11 years ago

I still cannot believe your accountant screwed up such an elementary accounting concept. As a fellow accountant, I would be absolutely mortified – it’s like a mathematician not understanding that 7 times 8 is not the same as 7 plus 8.

Shara
Shara
11 years ago

@ Camille

The 2 of 5 years law is no longer valid. Last September as part of the bailout it was changed to the amount of time used as a residence (though I think it still must be at least 2 years), so if you lived in a house for 2 of 4 years of ownership, 50% would be tax free and the rest would be subject to capital gains.

Jamie
Jamie
11 years ago

The idea of not wanting to make $250,000 if you have the opportunity to make slightly less, is that some tax hikes take the form of taking away tax benefits that those under $250,000 would enjoy. An example would not deal with the ordinary tax rates, but the capital rates. Those with higher income have more discretion regarding their capital gain rates. Something that is in the works under the Obama administration is to have a set of capital gains rates that differs depending on your AGI. So, if you can get below the $250,000 level then your capitam gains… Read more »

J.D.
J.D.
11 years ago

@Jimbo (#32) My accountant didn’t actually screw this up. He just didn’t look at it. I didn’t ask him to. I asked him to address the concept in the article, which he did. This is my fault, and not his. He’s not happy to be involved with this mess that I’ve created, and I don’t blame him. He sent me a detailed analysis of the whole scenario this morning that took into account everything — including marginal rates. 🙂 Here’s an analogy. Imagine you come to me with a story and ask me to comment on the plot. I comment… Read more »

Chett
Chett
11 years ago

J.D.,

You could teach. You have a gift of taking the difficult and breaking it down to digestable parts. Here is my question………….Who has an excel spreadsheet that will allow you to plug in a salary and it will automatically adjust for marginal rates and give the effective rate as a total? I am tempted to make one, but I’m sure someone out there already has one better than I could make. Anyone????

ryan
ryan
11 years ago

In order to be accurate, I think what you’re really asking for here is the latest edition of TurboTax. Of course you could make the basic spreadsheet, but since so much changes each year it becomes so complex that Intuit can justify the $50 or so for the software package each year. As an aside, I’m absolutely fascinated by the level and insight of all these comments. It’s definitely true how TurboTax or any tax preparation service ultimately seems to cause more and more misconceptions about even the basics of tax law. They prepare a correct return (not refund, haha,… Read more »

dave
dave
11 years ago

i feel bad for those poor people making over $250k a year. I hope after Obama’s tax increase they’ll still be able to put the caviar on the table and send their kids to their private catholic schools!

Shara
Shara
11 years ago

@Dave @ Accidental FIRE This is my fourth draft at this post in an effort to not be exceedingly rude: I know people who make $250k per year (and no, I don’t make near that). They don’t dine on caviar. They work hard and invest heavily in themselves, either via extreme levels of education or their businesses. Many of them do jobs and work hours that I would never choose to do, and have for years. I know PhDs who lived on ramen for years, MDs who slept only a handful of hours while as residents, engineers who worked in… Read more »

Elisa@Thrive
11 years ago

@ Massey and Andrew

I was just debating the flat tax at dinner last night.

Massey said it better than I did but I completely agree with her that it isn’t technically a regressive tax, it has a similar effect.

Curious about any good debates/info on the flat tax concept.

Tyler Karaszewski
Tyler Karaszewski
11 years ago

Eric (#2), Wise Money Matters (#6), and Dave (#38) all seem to express the same (seemingly popular) sentiment that people who make a lot of money can afford the taxes so they should stop complaining about it. I don’t make $250,000 a year, but I do make just a bit over half of that, which is still a fairly high salary, and I’d like to give my perspective as to why someone with a six figure salary doesn’t want to pay taxes any more than someone making $40,000 a year. Last year I made $142,000. I paid $42,000 in taxes,… Read more »

Michele
Michele
11 years ago

I have to add that depending on where you live in the country, $250,000 is not as high as you may think. If you are living in Hawaii, California, NYC, Washington, DC, or Chicago on that salary, you would be doing just fine. But all three of your children would not necessarily be going to private school and you would not be dining on caviar each night. For some perspective, I live outside of DC in a 1950’s 1,800 square foot ranch house with 3 bedrooms. My house is worth about $550,000 – today after the big housing bubble. Put… Read more »

Kevin
Kevin
11 years ago

Under Obama’s tax plan a person making $250,000 would pay another $46 of tax maximum for every $1,000 extra they made. I computed this by taking the highest current tax rate for 2008 = 35% and comparing it to what Obama would raise it to = 39.6%.

I don’t know about any of you, but I’d gladly take an extra $1,000 by agreeing to pay an extra $46 (total of $396) in tax. The argument that making additional money because it’s just going to be paid in taxes is ridiculous.

rugman11
rugman11
11 years ago

The woman claiming to be trying to reduce her income below $250,000 wasn’t entirely wrong. Part of Pres. Obama’s plan was to reduce the percentage applied to deductions on couples making more than $250,000. Thus, if I make $250,001 with $40,000 in deductions (charitable contributions, mortgage interest, student loan interest, etc.) under current law I would be able to deduct all of that at 33%, saving me $13,200 in taxes. Under Obama’s plan I would only be able to deduct that at 28%, saving $11,200 in taxes. However, if I made $249,999 I would still be able to deduct all… Read more »

Scott NJ DAD
Scott NJ DAD
11 years ago

Kevin’s comment about the US tax system being REGRESSIVE is correct. But don’t feel bad, the terms have been manipulated to confuse. The problem is the comparison you are making. To truly determine if a tax is regressive, progressive or neutral, you need to compare it to discretionary income. High earners have significantly higher discretionary income. Therefore, the taxes they pay are significantly smaller as a % of their discretionary income, than low earners. It is why, reducing taxes on the poor has so much more impact on the economy. The trickle down theories were always non-sense, rich people getting… Read more »

financialwizardess
financialwizardess
11 years ago

I have to point out that there is more to taxation than your tax rate. Many tax “rebates” are phased out once you hit a certain income. So for the article to have stated that someone is going to try to make $249,999 is absolutely a good strategy given that they may be unable now to subtract certain deductions. I know because we were phased out of our child credits. Instead of getting $1K per child, we only got $200. How’s that for a slap in the face? And it starts to phase out once you have over $110k in… Read more »

financialwizardess
financialwizardess
11 years ago

rugman11 #44, your example is perfect.

Snowballer
Snowballer
11 years ago

You know, just a crazy thought here, who decided that the government, the seat of all wisdom, knowledge and competence, should be the ones to set rules to make things “fair”? I’m not one of these “high income earners”. I work an office job in a retail store. My AGI is consistently under 25 grand. You know what, I understand that basically, I don’t have any damn money to pay for the cops, army, etc. and that the government’s going to take it from people richer than I am. Okay fine, whatever. But even at my income/tax level, I see,… Read more »

ryan
ryan
11 years ago

@snowballer This is ironic for me to argue against what you wrote, but I want to defend your coworkers a little. Just because they don’t pay taxes (after all the credits and deductions, etc.) doesn’t mean that they don’t add value to society. They get up most days, go to Wal-Mart, or wherever, and mop the floors and stock the shelves and work the registers of the store that lets people like me, who earn 10 times their income, keep more of my money by providing me with inexpensive labor/inexpensive products. There is still an incentive in this society for… Read more »

Shara
Shara
11 years ago

@ Scott NJ DAD WHAT taxes are reduced on the poor? The 40% bottom earners don’t pay income tax. There are other taxes, but those are usually flat (sales, property, etc.) so reducing them effects everyone, not just the poor. The only *tax* that hits poor higher than rich is lottery ticket sales. I am not sure about your logic that rich people don’t have much more to consume. Isn’t one of the issues discussed here recently about lifestyle inflation and the fact that 1)As you earn more your expenses inflate and 2)Even high earners can overspend their income? Isn’t… Read more »

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