Personal Finance Friday - Marginal Tax Rates

I was trying to think of subjects that I just assume other people understand but they actually might not...marginal tax rates came to mind.

If you understand how marginal tax rates work, please read no further, but if you don't, I'll try and explain them. Maybe you’re asking what are these weird words he is saying right now... even better read on!

In the United States we have what is called a progressive tax rate system. The more you make the more you pay in taxes. The idea is to let poorer people keep more of their money and to take more from wealthier people. Now how you implement this idea is very important, and our tax code uses marginal tax rates to do it. I'll explain why that is and what that is.

Marginal tax rates are tax rates that apply at different income levels. So for example in 2019 if you are single person, then you will pay 10% on your first $9,700 of income. $9700 x 10% = 970. That's the first level, the first margin so to speak :). Now if you make more than that you will move into the next bracket. What that means is that for every dollar above $9700 a new rate is applied, and as of right now that rate is 12%. So If you made $9800, your total tax bill would be $970 from above plus the tax from the other $100 in that next bracket. So $100 X 12% or $12... you'd owe $970 + $12 = $982.

Does that make sense? That keeps happening up the income brackets. All income from $9701 to $39,475 so $29,774 dollars worth ($39,475 - $9701) is taxed at 12%. Then all income from $39,476 to $84,200 is taxed at 22% (big jump!). All income from $84,201 to $160,725 is taxed at 22% and it goes till you hit the top bracket at $510,301 which is 37%. This works the same way for state income taxes as well.

So why is it set up like this? Seems a little confusing right? Why not just say if you make X all your income is taxed at Y? Well lets look at the example we had above. Say the tax code said if you make over $9700 you will be taxed at 12%. Well that person who made $9800 now owes $9800 x 12% = $1176, an extra $194 in tax. That person is now thinking... “Wow! Why the heck did I earn that extra $100?! That $100 of extra income actually cost me $194!!! I shouldn't have worked those last few shifts, I literally worked for a negative amount!” If you don't have marginal tax rates, you discourage people from working at certain points and the higher up you get in the scale the worse the “penalty” gets.

The same concept above is super important when you talk about welfare and other aid programs. If a program is setup improperly,  you may literally be discouraging people from going to find work because they are losing more than they are gaining by getting a job, at least financially.

So that is a quick summary of marginal tax rates. Taxes in general are way, way more complicated than this because of a bunch of other calculations that are layered on top of it all, but at the core that is how our tax system works and how tax amounts are calculated.