John M. Hoffman & Associates CPAs

Frequently Asked Tax Questions

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 by $33.33.

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 http://www.irs.gov/formspubs/article/0,,id=164272,00.html.

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 income.

Home