ARTICLE: Before you add a second income


Download full article here: marginal vs effective.pdf

Consider the following tax table for 2018 supplied by www.irs.gov:

Tax Rate

Taxable income, Single

Taxable income, Married Filing Jointly

10%

$0 – $9,525

$0 – $19,050

12%

$9,526 – $38,700

$19,051 – $77,400

22%

$38,701 – $82,500

$77,401 – $165,000

24%

$82,501 – $157,500

$165,001 – $315,000

32%

$157,501 – $200,000

$315,001 – $400,000

35%

$200,001 – $500,000

$400,001 – $600,000

37%

$500,001 or more

$600,001 or more

First a simple example:

Let’s say you’re filing as Single with $10,000 of taxable income.  Reviewing the first two columns above, $9,525 of the income will be taxed at 10%, and the remaining $475 will be taxed at 12%. The math is:

  • ($9,525 x 10%) + ($475 x 12%) = total tax due
  • $952.50 + $57.00 = $1,009.50
  • Effective tax rate = $1,009.50/$10,000 = 10.1% (NOT the marginal rate of 12%)

This is intuitive, as the large majority of the income is taxed at 10%, with only those dollars over $9,525 taxed at 12%.


Now a more complicated example:

Let’s say you’re Married Filing Jointly with $80,000 of taxable income.  While people may call this “the 22% tax bracket,” the effective tax rate is much lower.  The math here is:

  • ($19,050 x 10%) + [($77,400-19,051) x 12%] + [($80,000-77,401) X 22%] = total tax due
  • ($19,050 x 10%) + ($58,349 x 12%) + ($2,599 x 22%) = total tax due
  • $1,905 + $7,001.88 + $571.78 = $9,478.66
  • Effective tax rate = $9,478.66/$80,000 = 11.8% (NOT the marginal rate of 22%)

This is also intuitive, as most of the income falls within the 12% marginal rate, with some in the 10% rate, and a small amount in the 22% rate.


So what does this all mean?

  • Added income will fall into a new, higher, marginal tax bracket, but that does NOT mean the ENTIRE income is taxed at that higher rate. 
  • If a married couple with one income making $270K adds a second income of $50K, the marginal rate on the last dollars does indeed go from 24% (the marginal tax rate on $270K) to 32% (the marginal tax rate on $320K), but remember only a small amount of the new income and an even smaller amount of the total income – the dollars over $315,001 in this case -  will be taxed at that 32%.
  • Upon review of the “marginal versus effective” tax concepts, you may conclude “going into the next tax bracket” is not as material as you may have originally thought.