Understanding how the U.S. government's "marginal tax rate" works is an important building block in planning your free-tirement. Despite common misconceptions, it's actually fairly simple. Let's break it down:
A common misconception
Jeffrey makes a salary of
$100k. Because he makes a lot of money, he is in a higher tax bracket, say 25%. Therefore, every year he pays the federal government
$25k and gets to pocket the remaining
The misconception here is that all of your income is taxed at one unified rate.
Some fake brackets
We're going to use the following dummy tax brackets to keep the math simple. Also, we are going to ignore other tax factors like social security, deductions, etc..
$25k: 10% tax
$75k: 20% tax
$100k: 25% tax
How it really works
Instead of Jeff's income being taxed at one uniform rate, each "section" of income mentioned above (the fake brackets) get's taxed at the specified rate.
Suppose Jeffrey makes a salary of
- The first
$25kis taxed at 10% for a tax hit of
- The next
$50kat 20% (
- and the next
$25kat 25% (
The total tax he pays the government =
Effective tax rate
His "marginal" rate is 25%, or in other words, the next dollar Jeff makes will be taxed at 25%. However, we can also figure out his "effective" tax rate, or the percentage of tax paid from his salary. The equation is simple:
effective rate = total dollars paid to the government ÷ salary
Jeff's marginal rate: 25% Jeff's effective rate: 18.75%
Important Note: Always remember, the next dollar you make will be taxed in your highest bracket. When Jeff makes decisions involving his income (investing in a 401(k), asking for a raise, etc..) it's important for him to treat that money as being taxed at 25%, his "marginal rate".
The actual brackets (for 2017)
$418,400and up: 39.6%
$470,700and up: 39.6%
- Just because you are in a higher tax bracket doesn't mean all your money gets taxed at a higher rate. Only the income inside that threshold get's taxed at that rate.
- When considering a raise or drop in income, consider that money taxed at your "marginal rate" not your "effective rate" because dollars added or removed from your income are taxed in the highest bracket.
Now that you know how the U.S. federal government taxes income you can now make more educated decisions about your financial plans... it also happens to be a great party trick ;)
Happy free-tirement, The Retired Developer