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Tax rate, marginal tax rate, effective tax rate, tax brackets — tax terms can be confusing. But which one can best help you understand how much tax you’ll likely owe in any given tax year?
The federal income tax system is progressive, meaning the higher your income, the higher the percentage of your income you’ll pay in taxes. Maybe you’ve heard people talk about tax brackets or wondered what tax bracket you fall into — and how your bracket affects the rates at which your income is taxed. Knowing you’re in the 10% (or 24% or 37%) tax bracket is useful, but it doesn’t mean all your income will be taxed at that rate.
To get an idea of how much federal income tax you’ll owe, you need to understand marginal tax rates.
- What does “marginal tax rate” mean?
- Why are marginal tax rates important?
- Things to know about marginal tax rates
- How can marginal tax rates affect my taxes?
The federal income tax system currently applies seven tax rates to individual income: 10%, 12%, 22%, 24%, 32%, 35% and 37%. Each rate is tied to a tax bracket — a range of income that gets taxed at the associated rate.
Because the U.S. tax system is progressive, your income can fall into more than one bracket, so more than one tax rate can apply to your income. Your marginal tax rate is the highest bracket and associated rate that apply to your income.
Here are the tax rates and brackets for 2019 tax returns (due in 2020), based on filing status.
|Rate||Single taxable income||Married filing jointly and surviving spouses taxable income||Head-of-household taxable income||Married filing separately taxable income|
It’s important to note that tax brackets apply to taxable income. This includes more than just your wages.
Mostly, any income you receive is taxable unless tax law specifically exempts it. Some examples of taxable income include your wages and bonuses, unemployment benefits, capital gains, interest or dividends from investments, and canceled debts (with certain exceptions for bankruptcy). Your taxable income is the total of your ordinary income minus any adjustments and deductions you’re eligible for.
We’ll get into those adjustments and deductions later. For now, you can find your taxable income on Line 10 of Form 1040.
Let’s go through an example. Say Sophia is single, and her taxable income as shown on Line 10 of her Form 1040 is $80,000. Sophia’s marginal tax rate would be 22%. But again, that doesn’t mean all $80,000 is taxed at 22%. Instead, only her income over $39,475 (the beginning of the 22% tax bracket for single filers) is taxed at 22%.
Knowing your marginal tax rate is important because it can help you understand the tax consequences of earning additional income or taking certain deductions.
Going back to Sophia, let’s say she’s considering buying an investment property that would net $25,000 of income per year. That additional income would push Sophia into the 24% tax bracket. Having that information might factor into the decision of whether the income from that investment, after taxes and any deductions or exemptions she might be eligible for, is worth the time and effort she would need to put into managing the investment property.
Now that you know what marginal tax rates are, you can use them to help estimate the amount of income tax you’ll owe for the year. Let’s run the numbers to show how the process would work for Sophia.
Using the tax brackets
Because Sophia’s income is $80,000, three tax brackets and corresponding tax rates apply to her income. Here are the brackets, rates, income thresholds and tax for each bracket that apply to Sophia.
|Tax bracket||Income subject to tax||Tax|
|1st bracket||10%||$9,700||$9,700 x .10 = $970|
|2nd bracket||12%||$39,475–$9,700 = $29,775||$29,775 x .12 = $3,573|
|3rd bracket||22%||$80,000–$39,475 = $40,525||$40,525 x .22 = $8,916|
|Total tax = $13,459|
(Note that in the third tax bracket, the tax is rounded up from $8,915.50 to $8,916, because the IRS rounds up.)
If Sophia earned more income, she could repeat the same process for each bracket until she reached the highest bracket of 37%, which applies to all income over $510,300 for single taxpayers in 2019.
Of course, if you don’t want to do all the math to figure your tax, the IRS basically does it for you by issuing tax tables each year and providing them in the instructions for Form 1040.Learn how to read a tax table
Marginal tax rate vs. effective tax rate
Maybe you’ve also heard the term “effective tax rate” and wondered how that differs from marginal tax rate. Your effective tax rate, also known as your average tax rate, is the actual percentage of your income that you’ll owe to the IRS. To calculate your effective tax rate, you simply divide your total tax liability by your taxable income.
For Sophia, the effective tax rate would be 16.8%, or $13,459 divided by $80,000. So while her marginal tax rate is 22%, Sophia’s effective tax rate is much lower, because the 22% tax rate doesn’t apply to all her taxable income in our progressive tax system.
Once you understand marginal tax rates, you can use that information for tax planning. As noted above, your marginal rate applies to your taxable income, which is your total income minus any adjustments or deductions.
Examples of adjustments to income include contributions to a health savings account, self-employed retirement plan, and IRA and student loan interest paid. You’ll find them on Schedule 1 of Form 1040. Deductions are either the standard deduction or itemized deductions for things like mortgage interest, state and local taxes, and charitable contributions. With some tax planning, you may be able to lower your taxable income, and thus the amount of tax you’ll pay, by taking advantage of certain adjustments and deductions you’re eligible to take.What are the standard deduction amounts for 2019?
Let’s say Sophia will receive a $5,000 bonus in 2019, pushing her into the 24% tax bracket. She’s also deciding whether she should make a $1,000 donation to charity at the end of 2019 or wait until next year. If her bonus is a one-time event, Sophia may get a better tax benefit from her contribution by making it this tax year, when she is in the 24% tax bracket, than she would by waiting until next year when she expects to drop back into the 22% tax bracket.
Knowing your marginal tax rate and where you fall in the tax brackets can be a big help in understanding how much tax you’ll owe and the consequences of changes in your taxable income. If your taxable income falls near the cutoff line between brackets, a little tax planning may push you back into a lower tax bracket and lower your tax bill.