16 September 2015
Those of us who work in the tax field tend to throw words and terms around that most people don't use on a regular basis. One such term is 'Top Marginal Rate'. I thought I'd take a little time to explain what this term means, and why it is important.
Our federal tax code is progressive, meaning as income increases it gets taxed at a progressively higher rate. These different rates are known as the marginal rates (or tax brackets), and they change every few years as the Congress and the President come to an agreement on who should be paying what, and how much.There are different marginal rate schedules for each filing status. The current marginal rate schedules for Single, MFJ, and HoH are shown in the table below.
As you can see, we currently have 7 different marginal rates ranging from 10% to 39.6%, and the different filing statuses pass through them at different levels of taxable income. Note this is TAXABLE income, not your gross income or your AGI. This is the income you are taxed on after all adjustments, deductions, and exemptions are taken into consideration. (Taxable income is found on Line 43 of form 1040)
The table is good, but I think a chart does a better job of demonstrating the comparison between marginal tax rates.
At the lower income levels (where the vast majority of us live) the comparison is fairly dramatic. A single person zips through the lower marginal rates and has income exposed to the 25% and 28% rates much earlier than the MFJ and HoH filers. A single filer with $100,000 of taxable income will pay significantly more income tax than an MFJ filer with $100,000 of taxable income.
Your top marginal rate is the highest marginal rate at which your income is taxed. It is an important number to know because any tax savings you can generate are saved at your top marginal rate. Once again, I think a graphic will be useful. Let's take a look at a single filer and give her a fairly high taxable income of $300,000 to make it interesting.
This taxpayer's taxable income level exposes her income to 5 different tax rates, the highest being the 33% rate. The amounts of income exposed to each different rate are shown, as well as the tax generated at each rate and the total tax (of $82,607*). If this taxpayer's gross income (before deductions and exemptions) is $340,000 then her effective tax rate is $82,607/$340,000 = 24.3%.
Effective tax rates, while useful, can be misleading. Say, for example, this taxpayer was thinking about increasing her contribution to her 401K plan by $10,000. If she was analyzing her situation using her effective rate she would conclude this increased contribution would save her $2,430 (24.3% of $10,000) in taxes per year. However, this analysis is incorrect. Her top marginal rate is 33%. Any reduction in income exposed to taxes comes at that rate. Looking at the graph it comes off the top of the stack. Instead of saving $2,430 in taxes she would be saving $3,300 (33% of $10,000). Nearly $900 more in tax benefits than she originally believed.
Some quick math shows that her $10,000 contribution to her 401K results in an immediate tax savings of $3,300 - an instantaneous return on investment of 33%. If an investment advisor was promising you that kind of return I'd tell you it was a scam - too good to be true, but in this case the numbers are very, very real. You can create your own stellar ROI just by saving taxes at your top marginal rate.
The most important thing to remember from this post is that any tax savings you come up with are at your top marginal rate. If you have any questions or concerns, please contact me.
*For this example I have discounted that this taxpayer would also likely be exposed to Alternative Minimum Tax, the Medicare Surtax, and possibly the Net Investment Income Tax.
