Many things have changed in the world of tax returns like movement from paper to e-filing, use of cloud-hosted applications like Lacerte hosting and much more but some of the most basic things and terminologies of tax filing will never change and the marginal tax rate is one of them.
Many people must have heard about the term marginal tax rate while filing taxes but not everybody is aware of what it means and why it is so important. You may be thinking that since you have chosen a tax expert, you don’t need to go in the detail of your tax filing but such an approach can put you in trouble. Even after handling your tax filing to a tax expert, there are some parts of the tax return you should know if you want to keep yourself away from any type of hassle and understanding the importance of marginal tax rate is the first step towards self-awareness.
You should know that the federal tax income is progressive in nature which means that the higher your income, the higher the percentage of taxes you will have to pay. You must have heard the term tax bracket while filing taxes and wondered in which tax bracket you belong and how your tax bracket will affect the rate at which you are taxed. Knowing that you are in the 24% bracket is useful but it doesn’t mean that your every income will be taxed at the same rate. In order to understand how much federal income tax you owe, you will have to understand the marginal tax rate.
So, without wasting any more time, let’s go through the details of the marginal tax rate and understand why it is so important.
What is the marginal tax rate?
The marginal tax rate is basically the percentage of tax applied to your income for every tax bracket that you qualify. In layman’s language, the marginal tax rate is the percentage that is taken from your next dollar of taxable income above a pre-defined income threshold. You should know that federal, local and even state taxes are included in the marginal tax rate. Even federal payroll and self-employed taxes are included in it.
The current federal income tax system applies seven different types of tax rates to individual income. These seven tax rate are 10%, 12%, 22%, 24%, 32%, 35% and 37%. Every tax rate is related to a tax bracket which is basically a range of income which gets taxed at the associated rate. Now, since the U.S tax rate is progressive in nature, your income is not limited to a single bracket and it can fall into multiple tax brackets. This means that more than one rate can be applied to your income and the marginal tax rate is your highest tax bracket and the associated tax rate that is applicable on your income.
But one of the most important things to keep in mind is that the tax bracket is applicable on taxable income only and this includes more than just your wages.
Usually, any income that you get is taxable unless and until a particular tax law exempts it. Wages, bonuses, interest or dividend from investment and capital gains are some of the most common examples of taxable income. Taxable income is the total of ordinary income minus any type of deduction or exemption for which the person earning the money is eligible for. If you are looking for your taxable income then you can find it in Line 10 of Form 1040.
Let’s understand this with the help of an example. George is single and his taxable income according to the above-mentioned form and line $80,000. Now, his marginal tax rate will be 22%. But this doesn’t mean that the whole taxable income of $80,000 will be taxed at the marginal rate which is 22%. Only the beginning of the 22% of tax bracket for single filers will be taxes at 22%.
What is the importance of the marginal tax rate?
Knowing your marginal rate is paramount for you because it will help you in understanding the tax consequences of earning additional income or opting for particular deductions. By knowing your marginal tax rate, you will be able to know what amount of your raise or bonus you’ll be able to keep after taxes or whether it is a good option to contribute more tax-advantaged retirement account.
In order to understand the importance of knowing the marginal tax rate, let’s get back to the example of George. Let’s assume that George decides to buy an investment property that will net $25,000 of income per year. This added income will level up George into the tax bracket of 24%. Knowing this, it will help George in deciding the income coming from the property investment after the deductions and exemptions are worth the time and effort that George will put in managing that investment property.
A person knowing his marginal tax rate will be able to better manage his investment and he will also be able to make more profitable decisions. Marginal tax rate helps you understanding tax bracket, how much tax you will owe and what will be the consequences of it in your taxable income. So go through the above-mentioned explanation of marginal tax rate and manage your income and investment in a better way.
Saurabh Gupta is currently working as a senior content writer at MyQBHost, a QuickBooks cloud hosting company and the two things which matters the most to him is technology and writing.