With tax season quickly approaching, many Americans are yet again faced with the daunting task of filing their returns. Taxes are nearly always given a bad reputation. This is due to their confusing nature and the incredibly mysterious tax laws that the United States currently has. However, understanding the tax system of one’s country is one of the most important ways to be financially literate and responsible. By understanding the tax laws, you are able to potentially save money and regulate your spending so you know what to expect each year when it comes time to deal with the IRS.
In this article, I will explain a particularly confusing aspect of income taxes — marginal tax rates. There are many misconceptions, especially with regards to income taxes, as the United States taxes different income brackets at different rates. This may seem difficult to understand at first, but it will become clearer soon.
Marginal Tax Rate Brackets
As of 2020, the tax brackets for earned income are shown above. For the sake of simplicity, only focus on the “Single Individual” column on the left. The “Married Individuals” column on the right simply means that a married couple is filing their taxes jointly as one income, meaning they get lower tax brackets. To file as a Single Individual means that an individual is eligible to file as a single person in the eyes of the IRS.
As you can see, there is a “Rate” on the very left, with tax rates up to 37%. This is the marginal tax rate. For each rate bracket, you owe that given rate on the income that is specified for each bracket. This will make more sense in one moment.
Suppose you have an annual taxable income of $50,000, and you are filing as a single filer. Note that we are ignoring deductions and other factors that could potentially decrease your federal income taxes owed, such as a standard deduction of $12,200. To find your total federal income tax owed, first check to see where you fall in terms of the highest marginal rate. Since the annual taxable income is $50,000, you would find that this corresponds to a top rate of 22%, for incomes between $40,125 and $80,250.
First Marginal Tax Rate
To find the federal income tax owed, first we deal with the first marginal rate of 10%. This rate applies for income from $0 to $9,875. This means that your first $9,875 earned is taxed at a rate of 10%. Thus, the total federal tax income owed for this tax bracket is 10% of $9,875, or $987.50.
Next Marginal Tax Rate
Next, we will go to the 12% bracket. Here, all income from $9,875 to $40,125 is taxed at the marginal rate of 12%, meaning our next $30,250 earned is taxed at a rate of 12%. Thus, we owe 12% of $30,250, which is $3,630 for that bracket.
Final Marginal Tax Rate
Finally, we are at the top bracket. Here is where it gets complicated. Since we earn only $50,000, we are going to be paying the rest of our income at a top marginal rate of 22%, even though this bracket goes all the way up to an income of $84,200. Since there is only $9,875 ($50,000 – $30,250 – $9875) left to be taxed, this $9,875 is taxed at a rate of 22%. Thus, we owe 22% of $9,875, which is $2,172.50 for that bracket.
Finally, we add all of the taxes calculated up to find the total federal income tax owed. This is $987.50 + $3,630 + $2,172.50 = $6,790, so your total federal income tax owed is $6,790.
Not surprisingly, there are many misconceptions about marginal taxes. You may hear people say “I paid a 35% federal income tax this year.” This statement is misleading, as it may lead you to believe that a 35% rate was paid on all taxable incomes. This is not true. This was simply the highest marginal rate that could be taxed with that person’s income.
As you can see from the example we did above, the total federal income tax owed was $6,790. Dividing this number by $50,000, our income, would give us a percentage of 13.58%. If the hypothetical taxpayer in this scenario were to say “I paid a 22% federal income tax this year,” referring to the top income bracket in which they owed taxes, they would be misleading you. Their “effective tax rate” was really only 13.7%, much less than 22%.
If you are a taxpayer, it is important to understand the tax laws, and how your taxes work. Failing to understand what you owe can result in confusion and a failure to spot deficiencies in your calculations. This may cause you to owe more than you actually should.