What’s My Marginal Tax Rate?

[Note from Editor: This is a guest post from reader Bob’s not my name.]

Did you know that the highest marginal tax rates are paid by families with students in college? The modern tax code has made it very difficult for Americans to know their marginal tax rate. Marginal rate is a critical criterion for making investment and personal finance decisions: Should I contribute to a Roth IRA or a Traditional IRA? Should I sell this mutual fund now or wait until January? Is a Flexible Spending Account worth the hassle? Is my employer’s post-tax disability insurance premium a good deal or a bad deal?

Your marginal rate is how much income tax you’ll pay on your next dollar of income.* How do you determine that? First you need to determine your nominal tax bracket. Nominal tax brackets are based on taxable income, NOT gross income. A two-earner family with three kids might have taxable income $80,000 lower than gross income.

That’s only part of the story, however. Increasingly, the tax code looks to your Adjusted Gross Income (AGI) rather than your taxable income. Your AGI is at the bottom of page 1 of your Form 1040. Tax credits, eligibility for certain IRA contributions, the Affordable Care Act tax on investment income, the American Taxpayer Relief Act phaseouts of personal exemptions and itemized deductions, some college expense deductions, and many other tax benefits and penalties are based on AGI or Modified AGI (basically AGI adjusted in some way specific to the credit or eligibility). Some of these phaseouts create very high marginal tax rates — even approaching 100% — so it’s important to know which ones affect you.

Here’s how that happens: Imagine a $2,000 tax credit that is linearly phased out over a $20,000 range of AGI. That means each $100 increment of AGI costs you $10 in taxes, so the phaseout creates an incremental 10% tax — you thought you were in the 25% bracket, but it turns out your marginal rate is 35%.

Here’s a real example: The Child Tax Credit phaseout adds 5% to your marginal rate. The phaseout is based on AGI and is not inflation-adjusted, so that now, more than a decade after its introduction, the Child Tax Credit phaseout almost completely overlaps the 25% bracket for American families with three or four children — they jump straight from a 15% marginal rate to a 30% marginal rate … and if their income goes up their marginal rate drops to 28%. Throw in a deductible 6% state tax and these numbers are roughly 20% -> 35% -> 32%.

Many of these phaseouts target families making $125,000-$200,000, so they often overlap, yielding very high marginal rates — higher than anybody pays outside this band.

* Aggregating tax rate across major blobs of income is also useful for major life decisions. For example, a family with three kids pays about 5% federal income tax on its first $125,000 of income, but 30% on its next $75,000 of income. When you’re used to paying almost no income tax, giving up a third of your income may come as a surprise. Understanding this will help with major decisions such as: Should we move to a high cost of living area to accept this higher paying job? Now that the kids are all in school should I return to work for the second income? Thanks to the bull market, we finally have enough money to buy a house – is there any problem with selling all our stocks immediately?

Read the following sections to see which AGI-based taxes affect your marginal rate. These sections are by no means complete (I left out some of the low income credits, and also the ACA insurance subsidy, since Harry just covered that in a column), but I hope this covers the AGI-based taxes that affect most readers. MFJ refers to Married Filing Jointly, S to Single or Head of Household, except where HoH is different and is listed separately. All numbers are for 2014. The student loan deduction will also reduce state tax, so I assumed a 5% effective state tax to show the aggregate effect of the phaseout on your total marginal rate. Finally, note that the incremental rates listed pile on top of your 15% long term capital gains rate, too.

De Facto College Financial Aid Tax

Amount at Stake	47% of income net after federal tax
AGI or MAGI phaseout	About $100,000 – $200,000 gross income, depending on school and number of students in family
Incremental tax rate	Up to 35%
Inflation- adjusted?	N/A
Comments	Not technically a tax and not AGI-based, but has the same effects

Lifetime Learning Credit

Amount at Stake	$2,000
AGI or MAGI phaseout	MFJ $108,000 – $128,000 S $54,000 – $64,000
Incremental tax rate	MFJ 10% S 20%
Inflation- adjusted?	Yes

Child Tax Credit

Amount at Stake	$1,000 per child under 17
AGI or MAGI phaseout	MFJ > $110,000 S > $75,000
Incremental tax rate	5%
Inflation- adjusted?	No
Comments	Non-overlapping, so the top of the phaseout is $110,000 + (number of kids * $20,000)

Education Savings Bond Program

Amount at Stake	interest on cashed savings bonds
AGI or MAGI phaseout	MFJ $113,950 – $143,950 S > $76,000 – $91,000
Incremental tax rate	In theory up to 33%, typically far lower
Inflation- adjusted?	Yes
Comments	Divide total interest by $30,000 (MFJ) or $15,000 (S)

Student Loan Interest Deduction

Amount at Stake	$2,500 deduction, worth up to $800
AGI or MAGI phaseout	MFJ $130,000 – $160,000 S $65,000 – $80,000
Incremental tax rate	MFJ up to 2.5% S up to 5%
Inflation- adjusted?	Yes
Comments	Maxed out for $37,000 of debt at the typical 6.8% interest rate

Alternative Minimum Tax

AGI or MAGI phaseout	MFJ $156,500 – $484,900 S $117,300 – $328,500
Incremental tax rate	Replaces normal brackets with a 32.5% or 35% rate and the full weight of your state income tax
Inflation- adjusted?	Yes

American Opportunity Tax Credit

Amount at Stake	$2,500 per student
AGI or MAGI phaseout	MFJ $160,000 – $180,000 S $80,000 – $90,000
Incremental tax rate	MFJ 12.5% per student S 25% per student
Inflation- adjusted?	No
Comments	Creates huge marginal rates for multi-student families

Adoption Credit

Amount at Stake	up to $13,190
AGI or MAGI phaseout	All $197,880 – $237,880
Incremental tax rate	33%
Inflation- adjusted?	Yes

Affordable Care Act Investment Income Tax

AGI or MAGI phaseout	MFJ > $250,000 S > $200,000
Incremental tax rate	3.8%
Inflation- adjusted?	No
Comments	Effectively applies to earned income if investment income straddles the threshold

ATRA Personal Exemption Phaseout

AGI or MAGI phaseout	MFJ $305,050 – $427,550 S $254,200 – $376,700 HoH $279,650 – $402,150
Incremental tax rate	1% * number of dependents (5% for family of five)
Inflation- adjusted?	Yes
Comments	Absorbed by AMT (i.e., non-additive)

ATRA Itemized Deduction Phaseout

AGI or MAGI phaseout	MFJ > $305,050 S > $254,200 HoH > $279,650
Incremental tax rate	1%
Inflation- adjusted?	Yes
Comments	Absorbed by AMT

[Photo credit: Flickr user Horia Varlan]