Many aspects of America’s income tax system are confusing at best, perhaps none more so than marginal tax rates. But understanding how marginal tax rates work can play an important role in your tax planning as a business owner. Here’s what you need to know.
What is a marginal tax rate?
A marginal tax rate is the amount of additional taxes — expressed as a percentage — that you pay on every additional dollar of taxable income. Your taxable income is your adjusted gross income less deductions, whether itemized or standard.
Under a progressive tax system, marginal tax rates increase as your taxable income increases. As a result, high-income individuals are taxed at higher rates than low-income individuals.
What’s my marginal tax rate?
Your marginal tax rate is the rate for the highest “tax bracket” that your taxable income falls into. A tax bracket is a range of taxable incomes.
For example, if your total taxable income puts you into the top tax bracket, your marginal tax rate is 37 percent. In other words, the next dollar you earn will be taxed at a 37 percent rate. But that doesn’t mean your entire taxable income is taxed at that rate (see below).
How do marginal tax rates work?
In reality, individual taxpayers generally pay multiple tax rates, with different rates applying to different slices of their taxable income. The higher your taxable income, the more rates you pay.
Here’s why: Once you calculate your taxable income—which is influenced by factors such as source of income, filing status, and eligibility for deductions—the marginal rates are applied to their respective tax brackets. Tax bracket income ranges vary based on filing status (single, married filing jointly, married filing separately, or head of household).
For 2022, the federal income tax brackets and the corresponding marginal tax rates for single filers are:
- 37 percent on incomes greater than $539,900 ($647,850 for married couples filing jointly)
- 35 percent on incomes greater than $215,950 ($431,900 for married couples filing jointly)
- 32 percent on incomes greater than $170,050 ($340,100 for married couples filing jointly)
- 24 percent on incomes greater than $89,075 ($178,150 for married couples filing jointly)
- 22 percent on incomes greater than $41,775 ($83,550 for married couples filing jointly)
- 12 percent on incomes greater than $10,275 ($20,550 for married couples filing jointly)
- 10 percent on incomes of $10,275 or less ($20,550 for married couples filing jointly)
The critical point to understand is that a marginal tax rate applies only to the income in its corresponding bracket—not to all of your taxable income. If your marginal tax rate is 24 percent, for example, you also pay rates of 22 percent, 12 percent, and 10 percent on portions of your taxable income.
Note: Individuals in the same tax bracket don’t necessarily pay the same amount of taxes. A taxpayer whose taxable income nudges them into the next higher tax bracket will have less taxable income at that rate and, therefore, fewer taxes than someone at the high end of the same income bracket. On the other hand, that second person could ultimately have a lower tax bill because of tax credits, which reduce tax liability on a dollar-for-dollar basis.
Confused? Let’s look at a simplified example for a single filer, using the 2022 brackets and rates, assume:
- Adjusted gross income: $125,000
- Less standard deduction: $12,950
- = Taxable income: $112,050
So the taxpayer has a marginal tax rate of 24 percent. But here’s how it plays out when it comes to calculating the taxes:
10 percent on income of $10,275 or less: $1,027.50 +
12 percent on income between $10,275 and $41,775: $3,780 ($41,775 – $10,275 = $31,500 x 12 percent) +
22 percent on income between $41,776 and $89,075: $10,406.00 ($89,075 – $41,776 = $47,299 x 22 percent) +
24 percent on income between $89,076 and $170,050: $5,514 ($112,050 – $89,076 = $22,974 x 24 percent) =
Total income tax (before tax credits): $20,727.50
Note: Remember that not all income is taxed in the same manner. Long-term capital gains, for example, are taxed at rates of 0 percent, 15 percent, and 20 percent, depending on your income. These rates are significantly lower than most marginal tax rates on ordinary income.
How does a marginal tax rate compare with an effective tax rate?
Your marginal tax rate doesn’t really provide a complete picture of your income tax liability.It only describes the tax rate on your highest amount of income. For a more useful assessment, you need to calculate the effective tax rate, which reflects how much you actually pay in taxes.
Your effective tax rate is basically an average of the different tax rates at which you’re taxed on your earned income (salary and wages) and unearned income (for example, interest and dividends).
It takes into account your deductions and credits, as well as other taxes, such as alternative minimum tax (AMT), self-employment taxes, and the net investment income tax. It’s usually lower than your marginal tax rate—especially if you’re a business owner with the potential to qualify for numerous deductions. Effective tax rates provide a better indicator of how much you should pay in withholding or estimated taxes.
Note: The effective tax rate for a corporation is calculated by dividing total tax by pre-tax earnings.
You can calculate your effective federal income tax rate by dividing the total tax (line 24 of your Form 1040) by the taxable income (line 15 on Form 1040). Using the example above—and assuming the taxpayer has no other taxes, business tax credits, or child/dependent tax credits—the effective tax rate would be:
$20,727.50 / $125,000 = 16.58 percent
The taxpayer is in the 24 percent tax bracket, but they don’t pay 24 percent of their taxable income in taxes; they pay only 16.58 percent.
Note: To determine your most accurate effective tax rate, you’ll need to also include your state and local taxes in the “total tax” element of the formula. If you pay FICA taxes, you also would include those.
How does a marginal tax system compare with a flat rate tax system?
Flat rate, or regressive, tax systems apply the same percentage tax rate to all taxpayers, regardless of income. Such systems generally don’t allow deductions or exemptions, nor do they tax investment income.
Although the federal income tax system is progressive for individual taxpayers, several states apply a flat tax rate or are contemplating shifting to such a system. In addition, C corporations pay a flat federal income tax rate of 21 percent.
How do marginal tax rates affect the value of deductions?
The bottom-line value of a tax deduction depends on the taxpayer’s marginal tax rate. So, if you pay the top marginal rate of 37 percent, each dollar in deductions is worth 37 cents. For example, because a $1,000 deduction reduces a taxpayer’s income in the 37 percent bracket, that makes the deduction worth $370 ($1,000 * 37%). This makes the deduction more valuable than if a taxpayer’s top marginal rate was in the 24 percent bracket where it would only be worth $240 ($1,000 * 24%)
This can play a part in your tax planning. You might, for example, prefer to bunch your charitable donations into a year when you’re in a higher tax bracket than usual because the charitable contribution deduction will be more valuable than in other years when you’re in a lower bracket.