Tax Brackets and Marginal Tax Rates: Understanding How They Actually Work

Do you know what federal tax brackets are and the tax rates that apply? If you’re unsure, you’re not alone. Many people are under the impression that the more they earn, the higher their tax bracket will be. Well, that’s true, but it doesn’t mean you pay the higher tax on all your earned income. Instead, your tax bracket gets progressively higher. Say what? Fortunately, it’s not as complicated as it may sound.

Although tax accounting is one of those rare topics that, at least for most nonaccountant types, can be highly stressful and exceptionally boring at the same time, it’s a good idea to know what marginal tax rates really mean. And because tax time comes only once a year, we don’t normally spend much time on a topic that, ultimately, many of us would rather avoid despite its importance to everyone’s bottom line.

Understanding the basics of how much tax you’re likely to end up paying may clear up some mistaken assumptions and help with your tax planning going forward. 

Tax Changes

Remember all that contentious talk about the tax reform bill that more or less dominated political media toward the end of 2017? Well, the bill passed, meaning that a number of significant tax law changes likely affected how much you owe Uncle Sam (or how much Uncle Sam owes you).

But to fully understand the new legislation, at least the part concerning your tax payment or return, you’ll need a solid grasp of these two terms: tax brackets and marginal tax rates.

What Is a Tax Rate?

A tax rate is simply the percentage at which you’re taxed. Here’s an example:

• Suppose you just entered the workforce, you’re one of a couple filing jointly, and after all deductions and tax credits, your adjusted gross income is $18,000. 
• Next, suppose the tax rate on your income is 10%.
• The total dollar amount of taxes that the federal government will claim on your income that year will be $1,800.

So far, so good. However, there’s another important thing you need to know: The United States uses a progressive tax system, meaning that the more income you earn, the higher your tax rate. Consequently, people earning lower incomes will be taxed less than those earning higher incomes.

What Are Marginal Tax Rates?

Currently there’re seven tax rates. These marginal tax rates generally divide taxpayers into seven different tax brackets, ranging from the lowest to highest income levels. And these rates are marginal rates, meaning that as you move from one bracket to the next, you’re taxed at a higher rate only on the income earned above the previous threshold. Take a look at the table below.

For example, suppose you’re a single filer and you earned $85,000 in 2019. You’d pay 10% of the first $9,700 in earnings; 12% on the money you earned from $9,701 to $39,475; 22% on the income earned from $39,476 to $84,200; and finally 24% of your earnings above $84,200 (up to your total earnings of $85,000). Thus, you’d progress through four different tax levels. That’s what is meant by marginal rates.

Income Tax Bracket Thresholds

Although the number of marginal tax rates stayed the same after the tax reform bill passed, the rates were different. The marginal tax rates in 2017 (before the tax reform) were 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. With the exception of the 10% and 35% brackets, the current tax rates are lower across the board. You can use a reliable tax calculator to get a better sense of how the new tax brackets apply to your income levels. You may also wish to consult a tax professional for a more comprehensive view.

In summary:

• A tax rate is the percentage at which you’re taxed (in this case, we’re talking about federal income tax rates).
• A tax bracket table shows how different tax rates correspond to different income levels.
• Marginal tax rates mean you’re taxed at one rate until the top of a given income threshold. Moving into a higher bracket means you’ll pay a higher rate only on the income earned above the previous bracket. 
• There are seven marginal tax rates, with the lowest tax bracket at 10% and the highest at 37%. Income threshold levels for the different brackets may change from year to year as legislation is enacted.

Earning a higher income may put you in a higher tax bracket, but that doesn’t necessarily mean you’ll have less money left over. Now that you have an understanding of tax brackets and marginal tax rates, you can plan accordingly for the upcoming year.  

TD Ameritrade does not provide tax advice. Clients should consult with a tax advisor with regard to their specific tax circumstances.