A:

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.

marginal1.gif

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.

marginal3.gif

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.

RELATED FAQS
  1. What's the difference between the marginal tax rate system and a flat tax?

    Find out about the difference between marginal tax rates and flat taxes. Gain insights on both systems and the arguments ... Read Answer >>
  2. What is the income breakdown for the effective tax rate?

    Read about the effective tax rate, how the marginal income tax brackets affect it and how the denominator in its formula ... Read Answer >>
  3. What is the difference between a state income tax and a federal income tax?

    Learn the difference between state income tax and federal income tax based on tax rates, deductions, tax credits and taxable ... Read Answer >>
  4. What are the differences between regressive, proportional and progressive taxes?

    Understand the differences between the most common tax systems including regressive taxes, proportional taxes and progressive ... Read Answer >>
  5. How can I lower my effective tax rate without lowering my income?

    Discover how to reduce your effective tax rate without losing income by maximizing adjustments and deductions, earning tax-free ... Read Answer >>
  6. What is the difference between a regressive tax versus a progressive tax?

    Determine how progressive and regressive taxes impact your personal finances, and learn more about how you pay both types ... Read Answer >>
Related Articles
  1. Economics

    Comparing Regressive, Proportional and Progressive Taxes

    Learn about the basic differences between three common tax systems.
  2. Taxes

    Federal Tax Brackets

    Why do we have income tax brackets? What do they do for us? Read this to understand the basics and where to find your own bracket.
  3. Taxes

    The History Of Taxes In The U.S.

    The number of taxes that we now consider a given did not always exist. Find out how they arose.
  4. Taxes

    How Getting A Raise Affects Your Taxes

    Many people think they may actually make less overall because they are paying more taxes.
  5. Taxes

    Understanding Income Tax

    Income tax is a levy many governments place on revenue of entities within their jurisdiction.
  6. Taxes

    How Much Tax Do You Really Pay?

    When you add direct and indirect taxes together, your real tax rate is much more than you expected.
  7. Taxes

    Do Tax Cuts Stimulate The Economy?

    Learn the logic behind the belief that reducing government income benefits everyone.
  8. Taxes

    What is the Effective Tax Rate?

    The effective tax rate is the average rate at which an individual or corporation is taxed per year.
  9. Economics

    Calculating Net of Tax

    Net of tax is a figure that has been adjusted for taxes.
  10. Investing Basics

    Investment Tax Basics For All Investors

    Nothing can be said to be certain, except death and taxes even in your investments.
RELATED TERMS
  1. Dual Rate Income Tax

    An income tax rate structure in which two different tax rates ...
  2. Tax Rate

    The percentage at which an individual or corporation is taxed. ...
  3. Proportional Tax

    A tax system that requires the same percentage of income from ...
  4. Future Income Tax

    Income tax that is deferred because of discrepancies between ...
  5. Direct Tax

    A tax that is paid directly by an individual or organization ...
  6. IRS Publication 514

    A document published by the Internal Revenue Service that provides ...
Hot Definitions
  1. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  2. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  3. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  4. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  5. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
  6. Unlevered Beta

    A type of metric that compares the risk of an unlevered company to the risk of the market. The unlevered beta is the beta ...
Trading Center