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Introduction to marginal income tax brackets

One of the most common misunderstandings encountered when dealing with income taxes is the concept of marginal tax brackets, and how they are used to calculate your income tax.

Marginal tax brackets are a progressive tax bracket system, which means that the effective tax rate increases as taxable income increases. Marginal tax brackets are used to calculate your federal income tax, as well as state income taxes in most states that collect an income tax. In addition to personal income taxes, marginal tax brackets are also used when calculating federal and state corporate income taxes.

In the media and everyday conversation, you may often hear references to somebody’s “tax bracket” – for example, “Most full-time employees are in the 25% tax bracket”. This language can help create the false impression that individuals “in the 25% tax bracket” actually pay a full 25% of their income in taxes. This is not true, as we will soon see. Due to the nature of marginal income tax brackets, the actual amount of tax dollars paid by an individual in the top half of the 25% tax bracket is closer to 18% of their total income ^[1].

A marginal income tax means that the actual tax collected on each dollar you earn depends on the total amount you have earned between the first day of the tax year and the moment you earned that dollar.

For example, let’s consider a simplified version of the 2012 federal income tax brackets: ^[2].

Let’s say you earn a salary of $60,000 a year, or $5,000 per month. Starting on January 1^st (the beginning of the most commonly used tax year), you have earned a total of $0. Like everyone else, you start in the 10% tax bracket, which covers earnings from $0-$10,000. Therefore, you will owe 10 cents per dollar in income tax for the first dollar you earn – and for every dollar you earn up to the $10,000 cap.

On January 31st, you receive your $5,000 monthly paycheck. You have earned a total of $5,000 since January 1st, and all of the $5,000 you earned falls below the $10,000 cap for the 10% tax bracket. Therefore, you owe a total of $5,000 x 10% = $500 in federal income tax for your January earnings.

In February, you earn another $5,000. This is also included entirely in the $0-$10,000 tax bracket, so you also owe a total of 10%, or $500, of your February earnings in income tax. So far, you’ve earned a total of $10,000 since January 1st and have paid 10%, or $1,000, of your total earnings in federal income tax.

Now, because you’ve earned a total of $10,000 so far through February, you’ve reached the cap of the first tax bracket. The next dollar you make, the $10,001th dollar, will be included in the second  tax bracket – $10,000-$35,000. In this tax bracket you will pay 15%, or 15 cents per dollar, in federal income tax. When you receive your $5,000 paycheck at the end of March, you will owe 15%, or $750, in taxes.

Now, at the end of March, you have earned a total of $15,000 in wages and paid a total of $1,750 in income tax. This includes 10% of your January earnings, 10% of your February earnings, and 15% of your March earnings. You’re currently earning in the 15% tax bracket, but if we average the effective tax rate you paid on each dollar we find that you have only paid a total of 11.67% of your total income in taxes ^[3]. This is the nature of a progressive tax bracket system.

Here’s how the complete yearly tax breakdown looks for our example, for all $60,000 in wages earned from January 1st to December 31st. Wages are broken down into their applicable tax brackets, including total dollars earned and total tax paid in each bracket.

In words, here’s how your income is broken down into tax brackets:

• You paid 10% of your first $10,000, earned in January and February
• You paid 15% of yout next $25,000, earned from March through July
• You paid 25% on your last $25,000, earned from August through December

In our example, you find yourself in the upper half of the 25% tax bracket at the end of the year but you’ve only paid 18.33% of your income in taxes – a full 6.67% lower then your current tax bracket if taken at face value. We like to call this the marginal tax bracket effect.

One interesting observation of the marginal tax bracket effect is that its effects get less noticable as your total income goes up. While our previous example paid 6.67% less then the 25% tax bracket’s face value, an individual at the top of the 28% tax bracket earning $170,000 per year will pay about 24.24% of their income in taxes – only 3.76% below face value:

Why does the marginal tax bracket effect seem to diminish as you earn more? It’s a simple matter of rounding. The higher tax brackets are, by design, much wider then the lower brackets. For example, compare the $10,000 wide 10% bracket with the $90,000 wide 28% bracket. With more and more of your income falling into your highest tax bracket as your income goes up, the tax savings you get at the lower brackets become statistically less significant.

As you have seen in the previous examples, marginal tax brackets mean that the total percentage of income you pay in taxes is not the same as the face value of your highest tax bracket. While marginal brackets are somewhat more complicated to calculate then a simpler flat tax, they do come with benefits. Specifically, the marginal income tax system is designed to lower the overall tax burden on lower and middle-income taxpayers, while ensuring that taxpayers of all incomes pay the same marginal percentage in each respective bracket regardless of which bracket they fall in at the end of the year.

As the core of the American income tax system, understanding how marginal brackets work is a key step in understanding and taking control of your finances. Armed with this knowledge, you should be better prepared to make more informed tax and financial decisions in the future.

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