The marginal tax rate is the tax rate that a tax payer would pay on the next dollar they earn.
Tax is a fact of life. We all rely on government services every day, from the roads we drive on to the water we drink. But in the United States, we have a progressive tax system, meaning that the tax payer pays a different effective tax rate depending on how much they make.
For example, if John Doe files as single and made $50,000 in 2015, he would have paid:
- 10% in taxes on the first $9,225 ($922.50)
- 15% in taxes on the next $28,225 ($4,233.75)
- And 25% in taxes on the last $21,775 ($5,443.75)
So, John would pay ($922.50 + $4,233.75 + $5,443.75 = $10,600) on his 2015 tax return. Suppose John finds out that due to his hard work this year, he earned an end of the year bonus. What does John need to know to determine what he will pay in taxes on this bonus?
Since John’s next dollar earned is still inside the 3rd tax bracket (25%), that means his marginal tax rate is 25%.
In addition to calculating how much tax a tax payer will have to pay on any bonuses or commissions, the marginal tax rate is very useful in tax planning. Taking our example, suppose John earned his salary and bonus, but was downsized right at the end of the year. Further, suppose his boss gives him the option of receiving the bonus in December of 2015 or January of 2016. Since John has not earned anything in 2016, his marginal tax rate is in the lowest bracket, 10%. He should take the bonus in January to capitalize on his lower marginal tax rate and enjoy the (25% – 10% = 15%) tax savings.