A fundamental part of handling your personal finances involves tax management. This is especially relevant under a progressive tax structure where several income brackets exist. For each bracket, a specified portion of an individual’s taxable income is taxed at a given rate. As the income brackets increase, the tax rates do too. The idea behind this tax structure is to charge less taxes to those with lower income levels. For people with greater incomes, the reverse is true. In this case, the system is meant to tax wealthierpeople at higher rates. Given the nature of this tax system, a metric known as the marginal tax rate can provevery useful.
What is the marginal tax rate?
The marginal tax rate refers to the rate at which your next dollar of income is taxed at. This is usually centered on some base amount, or in other words, your current level of taxable income. It is relevant at both federal and provincial levels in countries that use a progressive tax system. However, make sure you don’t mistake this for the average tax rate. The average tax rate is the average amount of tax you pay across all of your income. As you can see, the marginal rate focuses on the effects of an additional dollar of income rather than your income as a whole.
How to find your marginal tax rate?
In a progressive tax structure, each portion of your income is taxed at an increasing rate. Knowing this, you must find which bracket your topmost dollar of income falls in. From there, determine whether adding another dollar of income would cause you to remain in that current bracket or move youto the next one. Whichever case is true, you have just found your marginal tax rate. Here’s an example.
Let’s look at a scenario of a single individual in the USA. To keep the example simple, let’s consider a taxable income of $50,000. The first tax bracket of 10% applies to the first $9,325 of income. The second bracket of 15% tax applies to the next $28,624 of income. The third bracket of 25% tax applies to the remaining $12,051 of the initial $50,000 taxable income. Therefore, an additional dollar of income for this individual would be taxed at a marginal tax rate of 25%. But just for the sake of an example, let’s say that an additional dollar of income actually made this person’s taxable income reach the next bracket of 28% tax. In this case, the marginal tax rate would then be 28%.
Why is it important to understand your marginal tax rate?
As we said at the beginning, it all comes back to tax management. Nobody likes paying more in taxes than they have to, right? Understanding the concept of a marginal tax rate can help you keep your taxable income within a certain income bracket.
Consider a situation where you suddenly have an increase in your amount of taxable income. This could be a raise at work, a new investment deal you’re working on, or any other source of additional income. Since your taxable income is growing, there’s the possibility that it could reach new tax brackets. You know what that means right? It means you’ll have to pay even higher taxes on that portion of income in the next bracket.
Is it possible to lower your marginal tax rate?
In the case that you do have additional earnings, understanding your marginal tax rate will help you to better allocate your money between savings accounts. For example, tax-deferred accounts can help to reduce your taxable income and stay in lower brackets. Knowing this, you may want to begin contributing more of your income to accounts that reduce your taxable income.
When it comes to personal finances, the more you know the better. So why not use all of the tools and strategies at your disposal to keep more money in your pocket? We recommend that you check out our article about
tax-sensitive investments since they can help manage your marginal tax rate.
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