Is the Average or the Marginal Tax Rate More Relevant?
When investing or earning money, the taxes you pay are an important consideration in calculating your return on investment. The income tax system has a range of rates or tax brackets with higher tax percentages as income increases. Your tax rates affect the after-tax money you receive on every dollar you earn.
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Income Tax System
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In the federal income tax system, taxpayers pay income taxes on the amount of taxable income earned for the year. The tax rules allow all taxpayers to deduct certain expenses or take a standard deduction, reducing taxable income. Income is divided into tax brackets with the income at that level taxed at a certain percentage. For example, if your filing status is married, the first $17,000 of income is taxed at 10 percent. The next $52,000 of income is taxed at 15 percent. At the time of publication, the tax bracket tax rates go up to 35 percent.
Average Tax Rate
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Your average tax rate is the simple calculation of dividing your total income tax paid for the year into your taxable income. This calculation averages your tax rate across the different tax brackets into which your income level may fall. For example, a single person with $100,000 of taxable income will have income falling in the 10 percent, 15 percent, 25 percent and 28 percent brackets. In the current year, the total income tax on this level of income would be $21,617. A single taxpayer with $100,000 of taxable income would have an average tax rate of 21.6 percent.
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Marginal Tax Rate
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Your marginal tax rate is the income tax rate for the highest tax bracket your annual income reaches. In the previous example, the marginal tax rate is the 28 percent tax bracket. Your marginal tax rate can be thought of as the rate you will pay on the next dollar earned. If your marginal tax rate is 28 percent, you will pay 28 cents from every dollar earned in taxes for every dollar you make above your current income level until you reach the next income tax bracket.
Investment Considerations
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The marginal tax rate is the determining factor when considering investment or additional income. As you earn more income, your average rate will increase because incremental earnings will be taxed at your marginal rate. You may also want to include your state and local income tax rates in your total marginal tax rate. For example, if you are in the 35 percent top federal tax bracket and live in a state like Hawaii with a top tax bracket of 11 percent, your marginal tax rate is 46 percent. Almost half of every extra dollar you earn will go to taxes.
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References
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