What Is A Marginal Tax Rate, And How Can You Use It To Save?

One financial term often used, but not always understood, is “Marginal Tax Rate” or Marginal Rate for short. It’s used so often that financial writers take its meaning for granted.

Today, let’s look at this term, understand what it means, what it’s not, and how we can use this information to our advantage.

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Let’s take a look at a tax rate schedule and consider a couple examples.

marginal-tax-rates
As a single person, you gross $40,000 and pay $4180 in federal tax. You are in the 10% bracket, right? Not so fast. When you divide these numbers, you get 10.45%, but this is your average rate. Start with the $40,000 gross, and you first deduct $3,650 as your exemption, everyone gets one. It’s $3,650 you pay no tax on.

Next, to keep it simple, I’ll assume you do not itemize. As a single person you get a standard deduction of $5,700. I call the sum of these two numbers your “zero bracket.” It’s $9,350 a single person will pay no tax on. This is subtracted from the gross $40,000, and produces a taxable income of $30,650.

Now, let’s go to the table above. The first $8,350 is taxed at 10% or $835, and the remaining $22,300 is taxed at 15% or $3,345. So, on $40,000 gross income, your marginal tax rate is 15%, even though your overall average tax is just over 10%.

It wouldn’t take much more income to be taxed at a marginal 25%, but back to the table, only the taxable amount above $33,950 is taxed at 25%.

How To Use Marginal Rates To Save

Very interesting, you’re thinking, but how can you use this to save on your taxes? First, being aware of your current bracket and potential future tax bracket can help you decide how to choose which retirement account method to use, the traditional 401(k) or IRA, vs the Roth 401(k) or Roth IRA. Say you project you will have a taxable income this year of $35,000. The last $1050 is taxed at 25%, so I’d suggest choosing to put only that amount in a traditional pre-tax account, the rest of the retirement money should be with post tax money, taxed at only 15%.

One more example. Your property tax , interest on mortgage, and state income tax (these are the three big itemized deductions) just exceed $5700, but not by much, so you fill out the schedule A to itemize, but only get $100 or so beyond the standard deduction.

Here’s a way to squeeze some savings out of this situation: In odd years, make the next year’s January mortgage payment in December, so you’ll have 13 months interest in that year. Also pay an extra six months of property tax from next year. Last, make any charitable deductions in January and December of this year. This should increase your itemized deductions quite a bit, and in the even years, when you only pay 11 months of mortgage payments, and just 6 months property tax, you hop on the standard deduction again. This strategy takes a little bit of effort but can result in quite a few hundred dollars in tax savings.

Any questions on marginal rates?  Post a question, and we’ll answer it in the comments here.

This article was written by Joe from JoeTaxpayer.com.

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Last Edited: 21st January 2014

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  1. says

    Thank you, Jason. I never tire of these topics, but needed to hit the publishing target or I could have gone another screenful.
    I’d add: you have right until filing your return the next April to use this to to decide how the direct the IRA money, pretax (traditional) or Roth. This works especially well if you are near the edge of a rate change, as in the chart above.
    /Joe
    JoeTaxpayer´s last blog ..Marginal Tax Rates Explained

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