How does the marginal tax rate system work?

The marginal tax rate is the rate of tax that income earners incur on each additional dollar of income. As the marginal tax rate increases, the taxpayer ends up with less money per dollar earned than he or she had retained on previous earned dollars. Tax systems that employ marginal tax rates apply different tax rates to different levels of income; as income rises, it is taxed at a higher rate. It is important to note, however, that the income is not all taxed at one rate but at many rates as it moves across the marginal tax rate schedule.

The above is a simple example of a marginal tax rate schedule. It illustrates the rate at which various levels of income are taxed. As income rises, each dollar of income above the previous level is taxed at a higher rate. If a taxpayer earns more money and moves into a higher income level, marginal tax rates can significantly diminish the benefit of the additional income because it will be taxed at a higher rate. As a result, some believe that marginal tax rates are harmful to the economy because they discourage people from working harder to earn more money. However, it is important to note that although earning more money may increase income tax rate, a larger income will still be taxed at more than one level. The chart below illustrates how marginal tax rate works.

As the graph shows, it may be best to think of the example in terms of income that is growing from $0 to $120,000. As it moves towards $120,000 it incurs different tax rates. Therefore, income between $0 and $20,000 is taxed at 10%, so the tax owed is $2,000 ($20.000 x 10%). Then income moves into a new marginal tax rate (20%). As it grows above $20,000, the $120,000 income earner owes $4,000 in tax ($20,000 x 20%) for this portion of income in addition to the $2,000 of tax incurred on the first $20,000. This is done at each income level up to the taxpayer's total income, in this case, $120,000. Based on the tax rate schedule above, the $120,000 income earner pays a total of $38,000 in taxes based on the marginal tax rate system. This example also illustrates that not all of this taxpayer's income is taxed at the same rate. Therefore, only $2,000 of tax is owed at the lowest income level, while $6,000 of tax is incurred at the third level on the same amount of money ($20,000). Many people are confused by marginal tax rates, believing that the rate at which they will be taxed is a flat rate based on the income level into which they fall. According to this incorrect assumption, therefore, a $120,000 income would be taxed at a 50% rate, making the amount of tax owed $60,000.

For additional reading, see Tax Tips For The Individual Investor and Using Tax Lots: A Way To Minimize Taxes.

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