In the US, we have a progressive tax system, meaning that your tax rate goes up as your income goes up.
What confuses a lot of people is that taxes are also marginal, which means that your entire income doesn’t fall into one single tax bracket.
The marginal tax is the amount of tax you incur on each additional dollar of income.
Let’s look at the chart below and go through a simple example for an individual tax filer to explain this further.
For this example, let’s assume we have an individual who has an adjusted gross income (AGI) of $100,000 (AGI is the amount you earned less deductions taken). How much would he owe in tax?
If you look at the chart you’ll see that he is in the 24% tax bracket, but not all of his income falls in this bracket.
As you can see, he does not pay 24% tax on all the income he makes. He only pays 24% tax on the dollars that fall into that bracket.
This is what we mean by marginal taxes.
The other number to be mindful of is your effective tax rate.
The effective tax rate represents the percentage of a person’s taxable income that they pay in taxes. To find this number you divide your income by your total tax. For this example it would be 18.02% ($100,000 / $18,021 = 18.02), not 24%. This is important to understand because most people think they are taxed based on where their income lies within the tax brackets but they aren’t. So if someone makes $100,000, they often think they are in the 24% tax bracket, but only the dollars they made above $85,525 are taxed at that 24% rate. They are effectively taxed at ~18%.
The key takeaways here are that taxes are progressive, meaning that as your income goes up, so do your taxes. However, not every dollar you make is taxed in your top marginal tax bracket. This creates a lot of opportunities for tax planning. You can fill up tax brackets for Roth conversions to maximize that tax bracket. Or you can take advantage of accounts that reduce your taxable income so no dollars are in a certain tax bracket.
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• The Ultimate Guide to Understanding Taxes
• The Ultimate Guide to Automating Your Money
• The Ultimate Guide to Understanding Insurance
• A Young Professional's Guide to Estate Planning
• The Ultimate Guide to Understanding Equity Compensation
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