Comparing Marginal and Average Income Tax Rates

marginal_tax_rateThere was a mini-uproar this past week in the personal finance blogosphere. It seems that one veteran blogger published a guest post from another veteran blogger about the tax consequences of paying mortgage interest. The problem was that the author fundamentally misunderstood the difference between marginal and average tax rates. Surprisingly, the comments to the subsequent apology indicated that there are a lot of folks out there who do not understand the difference. So I decided to write a brief article about.

What are Marginal Income Tax Rates?

< Your marginal rate is the highest rate you are taxed on your taxable income. You are not taxed at your marginal rate on all of your income. The marginal rate applies only to that portion of your taxable income that exceeds the lower income threshold for that marginal rate. Everything else is taxed at a lower rate.

Here is the marginal rate chart for 2008 federal individual income tax purposes.

Marginal Tax Rates for 2008 Individual Federal Income Taxes
Marginal
Rate
Single Married Filing Jointly Head of Household Married Filing Separately
10% 0 - 8,025 0 - 16,050 0 - 11,450 0 - 8,025
15% 8,025 - 32,550 16,050 – 65,100 11,450 - 43,650 8,025 - 32,550
25% 32,550 – 78,850 65,100-131,450 43,650 -112,650 32,550 - 65,725
28% 78,850 -164,550 131,450 – 200,300 112,650 -182,400 65,725 - 100,150
33% 164,550- 357,700 200,300 – 357,700 182,400 – 357,700 100,150 – 178,850
35% over 357,700 over 357,700 over 357,700 over 178,850

 

The highest rate you can pay on any taxable income is 35%. According to the mistake that was made and to some of the comments I read, some people think that if your income exceeds $357,700, all of your income is then taxed at 35%. That is not the case. You are taxed at that rate only on that income that exceeds $357,000. The same is true for all marginal rates.

Let’s assume that you are married filing jointly with gross income of $100,000. Let’s then assume that your taxable income (after deductions and exemptions) is $80,000.  

You will pay taxes as follows:   

On your first $16,050 of income, you will pay 10% in taxes = $1,605.

On your next $49,050 of income ($65,100-$16,050), you will pay 15% in taxes = $7,357.

And, on your last income dollars of $14,900 ($80,000-$65,100), you will pay 25% in taxes = $3,725.

You can see that you are taxed at your highest (marginal) rate on only a small portion of your taxable income.

The tax tables used in the Form 104o Instructions do not make this clear, which is one reason why some people get confused.

What is Your Average Tax Rate?

Understanding your marginal rate now makes it easy to determine your average tax rate.

For the example I used above, your total taxes paid are $12,687. Therefore, your average tax rate = $12,867/$80,000 = 15.9%.

You can also compare different tax rates such as a percentage of your gross income: $12,867/$100,000 = 12.9%.

Other tax experts would be interested in things such as your effective tax rates, taking into account tax credits that are substracted after you calculate the taxes owed from the tax tables.

Obviously, this can get a little bit complicated. You have to be careful comparing one person’s so-called “tax rate” to that of another person unless you are certain you are comparing apples to apples.

Here is the bigger problem:  For a lot of us, those marginal rates are going up.


Comments

  1. says

    Dear webpage owner,

    thank you for this thoughtful example of a US taxation. I plan to use your example (for the gross income of USD100K) in my upcoming lecture on taxation. I hope you do not mind. I assure you, that your website will be duly credited on the Powerpoint slide. If you give me also your name, I will be happy to include it to the corresponding slide, too.

    Regards,
    Anton Lebedev
    Associate professor for the
    St.Petersburg State University, Russia

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