John M. Hoffman & Associates CPAs
Marginal Tax Rate
"What is my marginal tax rate and what does that mean?"
Many people think that this should be a simple
question with a simple answer. They don't understand why we don't answer with a
quick "28%" response. Let us explain why this is not so simple. Your marginal
tax rate is the rate of tax, expressed as a percent, that you would pay on the
next dollar of income. If my marginal tax rates is 28% federal and 5.3% state,
that would mean that I would pay 33.3% on the next dollar of ordinary income. If
I earned another $100 of interest income, my income taxes would increase
First of all, never forget to consider your state
income taxes when you contemplate your marginal tax rate. For folks here in
Massachusetts, that is generally 12%.
Second, lets be careful as to what kind of income
we are talking about. Are we talking about ordinary income like wages or
interest, or are we talking about something different like capital gains or
qualified dividends that have special favorable tax rates?
Then we have to ask, how much income are we
talking about. The rate of tax on that next $100 of interest income may not be
applicable to the rate of tax on $1,000,000 of lottery income as the $1,000,000
of lottery income would likely jump through several tax brackets.
To make matters even more difficult, we have to
take into consideration the alternative minimum tax. For example if you are on
the verge of paying alternative minimum tax, and you are contemplating your
marginal tax bracket for purposes of assessing the after tax cost of buying that
Cape Cod vacation home, the alternative minimum tax might kick in not giving any
tax benefit to the additional real estate tax deduction.
As if this is not enough, what about the
implications of various phase outs built into our tax code. If you earn an
additional $10,000, what might that do to your personal exemptions, how much
might it reduce your medical expense deductions, your child tax credit for the
young one and the education credit for the older child?
This is not an all inclusive listing of the
complications. We do think that you should have an understanding of what your
marginal tax rate is but if you are contemplating a major transaction, asking us
to hypothetically drop that into your tax data is not that complicated a task. A
projection is a more valuable way to run the numbers and show you what the tax
impact may be rather that a quick "back of the envelope" type response.
However, in an effort to answer the question, or
what a person's marginal tax rate is, you can always look at your taxable income
(line 43 of page 2 of the 2006 form 1040) and compare to the IRS tax rate
schedule for your filing status. These rates can be found at the IRS website
Lastly we must address the age old myth the
problem with income "pushing a person into a higher tax bracket". Please
understand that a person's income fills tax brackets like water fills a swimming
pool. As each rate bracket of tax is filled with income, the subsequent income
simply fills the next bracket. Having additional income spill into a higher
bracket does not effect the rate of tax on the income that filled the lower
bracket. Under no circumstance does additional income adversely effect the other