Moaning about taxes is something almost all of us tend to do. But when you talk about your tax rate, you may actually have things wrong. Some people, for example, will complain that since they're in the 33% bracket, they lose a third of their income to taxes all the time. But in reality, our tax system is a progressive one, and so when we talk about tax rates, we're often referring to marginal rates.
Your marginal tax rate is the rate at which your last dollar of income is taxed. Once your income reaches a certain threshold, you'll pay a higher percentage of tax on your last dollars of earnings than you will on your first dollars of earnings. Your marginal tax rate is the maximum rate you'll have to pay -- but it isn't your overall rate.
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Marginal tax rates
The more money you earn, the more your tax rate will climb. But that tax rate only applies to your highest dollars of earnings. In fact, as you'll see in the table below, all single tax filers pay the same amount of tax on their first $9,325 of earnings -- 10%. Once you start making more than that as a single filer, your tax rate on your subsequent earnings will go up accordingly, as follows:
DATA SOURCE: TAXFOUNDATION.ORG.
Now joint filers have different marginal tax rates than single filers, as shown in the following table:
DATA SOURCE: TAXFOUNDATION.ORG.
If you've ever heard a couple bemoan the so-called marriage penalty, it's because of the way tax brackets are set up for joint filers versus single filers. As an example, imagine you have two single filers earning $120,000 per year and falling into the 28% marginal tax bracket as a result. Upon getting married, those same filers would have a combined income of $240,000 that would push them into the 33% bracket, which means they'd wind up paying more taxes on their highest dollars of income.
Of course, the opposite can also happen. If you have one member of a couple earning considerably less than the other, their combined earnings might drop them down into a lower tax bracket, thus reducing what they pay on their highest dollars of earnings.
Your marginal tax rate versus your effective tax rate
Some people think that when they fall into a certain tax bracket, they'll be paying that percentage of tax on all of their income. That's not true. As we just saw, being in the 28% tax bracket doesn't mean all of your income is taxed at that rate; just some of it. When you talk about the overall percentage of your income you lose to taxes, you're actually referring to your effective tax rate.
Here's an example. Say you're a single tax filer earning $60,000 a year with no deductions. You'll pay $5,226.25 on your first $37,950 of income, plus 25% on your remaining $22,050 of income, which is $5,512.50. Your total tax liability for the year will be $10,738.75, and your effective tax rate will be just under 18% -- yet your marginal tax rate will be 25%.
While there are things you can do to get yourself into a lower tax bracket, such as increase your charitable donations or contribute to a retirement account, at the end of the day, dropping down a step on the marginal ladder may not make a huge difference. Rather, you're probably better off focusing on ways to lower the amount of taxes you pay on a whole.
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