Marginal Tax Rates and You

There’s a good chance you’re paying less in taxes than you think.  Why, you ask?  Because of the difference between your marginal tax rate and your overall tax rate. (Note: these discussions are going to focus on the American tax code, as that’s the one with which I’m the most familiar.  Apologies to any international readers, but I can’t really comment on your tax system.)

When most people talk about their tax rate or their tax bracket, they are discussing their current marginal tax rate.  This is the tax rate you will pay on the last dollar of (taxable) income that you earn.  It’s important to know this tax rate so you know how much you will pay should you earn any more money; if you are in the 25% tax bracket, when you earn one hundred dollars more, you will have to pay $25 more in taxes.

However, the average tax rate you pay is the average of the tax rates you pay on each segment of your income.  The first $8,350 of your taxable income, for example, is taxed at 10% (if you are single or married filing seperately), regardless of whether you earned $10,000, $100,000, or $1,000,000 the past year.  A complete tax schedule can be found here.

What are the consequences of this difference?  First, as already mentioned, your average tax rate is less than your marginal tax rate, and so you’re probably paying less in taxes than you might believe.  If you earned $50,000 in taxable, non-capital gains income, you would be solidly in the 25% tax bracket.  But the total income tax you would pay is $8670.50, for an effective tax rate of 17%.  In the same way, your average tax rate will always be less than your marginal tax rate (unless you are earning less than $8,350 each year, in which case both rates will be the same 10%).

A second consequence is that going up a tax bracket will not have a huge impact on the amount of tax that you pay.  You occasionally hear people going to great lengths to stay in the same tax bracket, from foregoing raises to cutting down on overtime, for fear that moving to the next bracket would cause them to lose money.  However, as noted already, this is not the case; if you go from the 25% tax bracket to the 28%, you will only have to pay the higher tax rate on your additional income.  If you go from $82,000 to $83,000, for example, you will only pay an additional $272.50 in taxes as a result; the previous amount you were paying in taxes on the $82,000 will remain unchanged.  Moving up a tax bracket will decrease the amount of money you get to keep for each additional dollar of income, but will not require you to pay more on money you already earned.

Finally, and perhaps most importantly, it adds a bit of a wrinkle to choosing between a traditional and a Roth IRA, although not a huge one.  Because your traditional IRA (and traditional 401(k), as well) contributions reduce the amount of taxable income you have, they will effectively cut down your taxes by the marginal rate you are currently paying.  But on withdrawal of your money, you will be paying taxes according to the then-current tax schedule.  Roth accounts, however, use post-tax contributions, so it’s the current average tax rate you need to consider for the contributions.  Withdraws are tax-free, so it’s just the contributions you need to consider.

Confused yet?  Let’s look at an example to see how this difference could end up being a wash.  If you are earning $50,000 a year before your IRA contributions and put in the maximum amount (currently $5000), you will cut your taxable income down to $45,000 and reduce your taxes by $1250 (25% of $5000).  When you retire, if you withdraw $50,000 a year from your account, have no other taxable income, and the tax rates are still the same (a great big if, especially when you are like me and are decades away from retiring), you will end up paying the same 17% average tax rate on those withdrawals.  Compare that to a Roth; you will have to pay the 17% average tax up front, but when you take out your money at retirement, it’s tax free; you pay no additional taxes on the withdrawals.

Because in both cases, you will pay an average tax rate of 17% on your retirement money, it’s frequently noted that both a Roth and a traditional IRA have the same tax burden, as long as taxes stay the same.  Tomorrow, we’ll look into some of the other factors that will influence which type of IRA is better for you.


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