Marginal Tax Rates Explained

There is a common misconception among many people about how tax brackets and marginal tax rates function within the United States tax system.

This misunderstanding often leads to confusion and anxiety, particularly when individuals receive pay raises or bonuses that push them into a higher tax bracket.

The fear is that by moving into a higher bracket, they will lose money due to being taxed at a higher rate on their entire income. However, this is not how the tax system works.

In reality, the U.S. tax system is based on a progressive tax structure, which means that as an individual’s income increases, they pay a higher tax rate on each additional dollar earned. The key point to understand is that the higher tax rates only apply to the income within that specific bracket, not to the entire income.

Let’s create an example using the 2023 tax brackets for a single filer to illustrate how marginal tax rates work. Suppose we have a single filer named Alex who has a taxable income of $100,000 for the year 2023.

Based on the provided tax brackets, here’s how Alex’s taxes would be calculated:

1. The first $11,000 of Alex’s income is taxed at 10%.
2. The income from $11,001 to $44,725 is taxed at 12%.
3. The income from $44,726 to $95,375 is taxed at 22%.
4. Finally, the income from $95,376 to $100,000 falls into the 24% tax bracket.

To understand the marginal tax rate: the rate applied to the last dollar earned, Alex’s marginal tax rate is 24% because that’s the rate that applies to the top portion of their income. This does not mean all of Alex’s income is taxed at 24%, but rather that 24% is the highest rate applied to any part of their income.

Let’s calculate the exact tax owed by Alex to see the total impact of these brackets.

Based on the 2023 tax brackets for a single filer and an income of $100,000, Alex would owe $17,400 in taxes for the year. Alex’s total (effective) tax rate on a taxable income of $100,000 for the year 2023 is 17.4%. This means that, on average, 17.4% of Alex’s income is paid in taxes,

This calculation demonstrates how the progressive tax system works, with only the portion of income that falls into each bracket being taxed at that bracket’s rate.

This misconception about tax brackets can lead to people turning down pay raises or bonuses, thinking that the additional income will be taxed at a much higher rate and ultimately decrease their take-home pay. In reality, only the additional income that falls within the higher tax bracket is subject to the higher rate, while the income in the lower brackets continues to be taxed at the lower rates.

Understanding how tax brackets and marginal tax rates work is essential for making informed financial decisions. It can help individuals better plan their finances, such as deciding whether to invest in tax-deferred accounts or negotiating salary increases. By dispelling the misconception surrounding tax brackets, people can make better choices about their income and tax liabilities without undue fear or anxiety.