If I ask you point-blank "what is your marginal tax rate?" do you know the answer? If you think you know, write it down. If you are not sure, take your best guess. After you finish reading this post, see if you got it right.
The marginal tax rate is the tax you pay on your last dollar earned. It’s an important number to know because at the end of the day, if you earn one extra dollar, what you can put into your own pocket or spend after taxes are paid is what really counts. That number would be 1 – marginal tax rate.
If my marginal tax rate is 95%, I will not bother putting in the effort to earn that one extra dollar because it’s just not worth it for me to net only 5 cents. I’d rather relax and enjoy my leisure.
The correct answer to the question "what is your marginal tax rate?" has to include at least two another questions:
- On what income?
- What will I do with it?
The tax system is complex. That’s an understatement. We get taxed differently depending on how the income is earned and how it’s used. When you have income from multiple sources, which dollar is exactly your last dollar earned? When you put your money into different use, which dollar is exactly your last dollar?
I can think of many kinds of taxes:
- federal income tax
- state income tax
- local income tax
- Social Security tax
- Medicare tax
- mental health tax (for some lucky souls in California)
- disability insurance tax (in some states)
I probably left out quite a few more taxes.
Depending on whether your income is wages, self-employment income, interest, dividends, capital gains, Social Security, pension, withdrawals from different types of accounts, and depending on the exact circumstance of such income (capital gains from selling qualified primary residence versus selling a stock you held for less than 12 months; withdrawal from a Roth IRA versus from a traditional 401k plan; and so on), one or more of the taxes above don’t apply or apply at different rates.
If you use your last dollar earned on some preferred items, you get a zero rate or even a negative rate on some of the taxes above. Those are the tax deductions and tax credits, plus a few more that don’t show up on the tax forms, like contributions to a retirement plan or contributions to a health care flexible spending account.
On the other hand, you will pay even more taxes if you use your last dollar earned on some other things. Those are the sales tax, use tax, and excise tax. The rates are different depending on what you buy and where you buy.
- buy products in stores (rates for groceries and prescription drugs can be different)
- buy cigarettes
- buy gasoline
- stay at a hotel
- rent a car
- make a telephone call
- use electricity
That’s just a tip of an iceberg. When all is said and done, how many different taxes do you pay in a year? I would guess at least 20. Maybe over 100.
Have you figured out what your marginal tax rate is yet?
Sorry about the trick question. There isn’t a single marginal tax rate. If you create combinations like "income from wages donated to charity" and "interest from Treasury bills contributed to a 529 plan in New Mexico" you can probably come up with hundreds of different marginal tax rates just for one person.