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.
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Austin Frakt says
Bravo! Given the complexity, it is a miracle if we make anything close to a rational decision about anything.
JoeTaxpayer says
This is a topic I am close to. When we talk about Marginal Rates, we often are really referencing the Tax Brackets, which of course, are what they are. But as you note, the ‘tax on next dollar’ is often nowhere near that rate. I wrote (and linked from my name above) how a woman who otherwise would be in the 15% bracket has a “phantom rate” of 47% (yes – forty seven) on the next dollar she withdraws from her IRA.
Don says
Nominally, for me the major (marginal) taxes are 15% federal tax, 6% state tax, and 7.65% for my half of social security and medicare tax.
This understates things because I’m near the cutoff for the retirement savers credit, and that phase-out effectively pushes my marginal rate up; technically it is 4 million percent on the first penny over the cutoff, but I suppose that’s being a bit silly. Say perhaps that it is another 4% to my marginal rate and decreasing as my income goes up, leaving that boundary behind me.
It is worth noting that some of my marginal rates were substantially higher “along the way.” I have one block of income on which my marginal federal rate is 27.75%. I have another block of income on which my marginal federal rate is 22.5%. Each of those regions enjoys a higher marginal state tax rate for my wife as well.
Financial Samurai says
My marginal tax rate is 35%, and when Bush’s tax policy expires in 2011, it’s likely going to 40% federal. DEPRESSING!
It’s all about a FLAT TAX!
Chuck says
Just did the calculation. My federal marginal rate is 30%, even though I’m in the 25% tax bracket. Why? Because I have 3 kids, and I’m in the child tax credit phaseout zone. I was surprised by this fact.
That makes rolling into the 32.5% effective AMT bracket less of a concern than I thought it was. So, I suppose there’s looking at the bright side…
Finance girl says
28% federal, 0 state tax (wa state has none), and 9.8% sales tax.
PatentGuy says
I live in Cailfornia and I am “successful” (because I work constantly) self employed. In addition to the Fed rate of 35% (for one more year, anyway) our marginal state tax rate is 10.55%, but this is deductible from fed at the marginal dollar, so net is 10.55% * .65 = just under 7%. Then, there is medicare, 2.9%, of which half is deductible, for about 2.2% net. So, I have a marginal rate of just over 44%.
This will go to 48.5% when Bush brackets expire in 2011, and I assume go over 50% once the health care taxes or other self employment taxes such as FICA are raised, as promised by team Obama.
At some point, the Laffer curve kicks in. It’s easy to say you won’t work if your marginal tax rate is 95% – who would? But how about at 50%? Would you?
I am stuck in California for family reasons (and it is a nice place to live for the most part), but the irony is that I could probably do just as well, business-wise, in a nearby no income tax state like Nevada or Washington.
JoeTaxpayer says
PG –
Interesting question. I suppose it depends how much one is making, or has.
I often wonder why a billionaire chooses to keep working, taking time away from family and other activities. Then I realize, some of these guys are in it for the action. Their work is everything regardless of the income. You raise a good point, and as you know, Laffer is a chart with only two fixed points…..
Harry Sit says
PatentGuy – I draw the line at 50%. If I can keep 50% of what I earn, I’m working and paying taxes. If I get less than 50%, I’m really working for the taxman. The problem is it’s hard to stop at the marginal dollars, although it’s somewhat easier if you are self-employed. For people who work for an employer, working 75% of capacity is usually not an option.
PatentGuy says
TFB,
It’s easy to say you will draw the line at 50%, but until it happens, you don’t really know. For example, I can easily see Team Obama combined with California pushing the combined rate into the low 50% within a few more years. I guess we will find out.
I thought I had posted an earlier reply to JTP regarding “billionaires”, but apparently. I did not hit “submit”. The gist was: I am not a billionaire (Im short about $995M in assets …). But, I suspect most billionaires have much lower marginal tax rates than I do, because they make their billions through long term capital gains; not income. For now, the LTCG Fed rate is 15%. No Medicare tax; No SocSec Tax. I also suspect many billionaires are smart enough to locate themselves in a state that has no income tax (Bill Gates in Washington comes to mind), so the sate cap gains rate does not matter.
Thanks for a great blog.
JoeTaxpayer says
I meant it more in the sense that a billion dollars can easily fund a $20M/yr lifestyle, the marginal worth of money at that point is already minimal. Marginal tax rates mean far less to such a person than to you or me. I do understand, though, that these people actually drop in terms of tax bracket. There’s irony for ya.
PatentGuy says
JTP:
I agree it’s hard to understand why any billionaire would “work” – but I imagine the ones that do are “the man” at “work” and it is simply not comparable to what most of us view as working.
Regarding tax policy. Yep – the US taxes labor/wages; not capital gains. Even Obama seems reluctant to tax capital gains (“investment”) at the same rate that income is taxed. That debate (like the debate over how much to tax everything and anything) is ongoing …. The government is getting huge and it is past the point of ever shrinking. Americans (and others world wide) love their entitlements and conflate entitlements as “rights” like free speech.