Taxes can be a complex and often misunderstood topic. One area of confusion is the concept of marginal tax rates. Understanding marginal tax rates can help you better plan for the amount of taxes you owe and how much you should save for retirement.
So, let’s unlock the secret behind marginal tax rates.
What is a Marginal Tax Rate?
A marginal tax rate is the tax rate that applies to the next dollar of income earned. In the United States, the tax system is progressive, which means that as your income increases, the percentage of tax you pay increases.
For example, let’s say your taxable income for the year is $40,000. The tax rate for the first $9,875 of income is 10%, and the tax rate for income between $9,876 to $40,000 is 12%. This means that the first $9,875 of income is taxed at a rate of 10%, and any income earned above that up to $40,000 is taxed at a rate of 12%.
Calculating Your Marginal Tax Rate
Calculating your marginal tax rate can seem intimidating but is relatively simple. You can use the tax brackets and marginal tax rates provided by the IRS to determine your marginal tax rate.
To calculate your marginal tax rate, you will need to:
1. Determine your taxable income for the year.
2. Find your tax bracket by using the IRS’s tax bracket table.
3. Calculate your marginal tax rate by identifying the tax rate that applies to the next dollar earned within your tax bracket.
If you earn $40,000 per year, your tax rate for the first $9,875 is 10%. Any income earned above that up to $40,000 is taxed at a rate of 12%. Therefore, your marginal tax rate at a $40,000 taxable income is 12%.
Why Marginal Tax Rates Matter
Knowing your marginal tax rate can help you make informed financial decisions. For example, if you are considering taking on additional work or earning more money, understanding your marginal tax rate can give you a sense of how much tax you will owe on that additional income. Planning for tax bills can save you money in the long run and limit surprises come tax time.
Additionally, understanding how your marginal tax rate changes as your income grows can help you plan for retirement. Many financial advisors recommend saving enough money to be able to maintain your standard of living in retirement, but the amount you need to save can vary depending on your marginal tax rate.
For example, if you plan to retire with a taxable income of $60,000 per year and your marginal tax rate currently is 22%, you will need to save more than someone whose marginal tax rate is 12%.
Understanding marginal tax rates is essential when it comes to planning your finances. Knowing your marginal tax rate can help you make informed decisions about your income, how much you need to save for retirement, and how much tax you will owe. Take some time to understand and calculate your marginal tax rate. Taxes can seem daunting at first but learning the basics, including understanding marginal tax rates, can go a long way in making tax season easier and more manageable.