In order to have any valuable dialog about the Roth IRA, traditional IRA or 401(k), you need a solid understanding of marginal tax rates. The tax that you pay is not a fixed percent of your income. You first get to take a deduction against income or a minimum of the standard deduction, $5,950 for single, $11,900 for married filing jointly. You also take a personal exemption for each person in your household, worth $3,800 per person. In effect, this creates a “zero bracket” of $9,750 for singles, $19,500 for married filing joint (plus $3,800 for each child). Keep in mind, there are other credits and deductions you might be able to take. A state with high income tax, some real estate tax, etc, resulting in an even higher amount off the top before the rates below kick in. For sake of simplicity, we’ll assume the standard deduction, and I’ll be clear about how many exemptions are in a given example.
Say a couple has a gross income of $50,000. From above, their exemptions and standard deductions (no kids) totals $19,500, resulting in a taxable $30,500. Their total tax is $3,705. The next $100 would be taxed at 15%, so their tax bracket or marginal rate is 15%, but their average rate, sometimes called effective rate, is 7.4% (3705/50000). I find the mention of the average rate to be of little use. To me it’s a bit of math after the fact, but no more. The marginal rate, on the other hand, is the starting point for any decisions you might make regarding which type of retirement account you’ll use, pretax or post tax, as well as the timing of withdrawals from these accounts. It tells you the tax effect of the very next dollar of added income or dollar put into a pretax account.
In the future, we’ll refer to this chart and introduction on marginal rates from time to time. But for now, if you have a question on this, leave a comment, and ask.
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Single |
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| Taxable income is over |
But not over | The tax is | Plus | Of the amount over |
| $0 | 8,700 | $0.00 | 10% | $0 |
| 8,700 | 35,350 | 870.00 | 15% | 8,700 |
| 35,350 | 85,650 | 4,867.50 | 25% | 35,350 |
| 85,650 | 178,650 | 17,442.50 | 28% | 85,650 |
| 178,650 | 388,350 | 43,482.50 | 33% | 178,650 |
| 388,350 | 112,683.50 | 35% | 388,350 | |
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Married Filing Jointly |
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| Taxable income is over |
But not over | The tax is | Plus | Of the amount over |
| $0 | 17,400 | $0.00 | 10% | $0 |
| 17,400 | 70,700 | 1,740.00 | 15% | 17,400 |
| 70,700 | 142,700 | 9,735.00 | 25% | 70,700 |
| 142,700 | 217,450 | 27,735.00 | 28% | 142,700 |
| 217,450 | 388,350 | 48,665.00 | 33% | 217,450 |
| 388,350 | 105,062.00 | 35% | 388,350 | |
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I have found one use for average tax rate. Some retirement calculators (for instance http://www.flexibleretirementplanner.com) ask for your tax rate in order to determine your after tax funds in retirement. If you were to input your marginal tax rate (i.e. 15 or 25%) the result would way overestimate your tax bill. So I use a reasonable guess for average tax rate instead, which is more like 5-10% for those of us planning to be in the 15% bracket.
Excellent point Dave, I understand. As long as the person planning doesn’t see the 10% average and think the next $1,000 or $10,000 will be taxed at the same average rate. When I look at my average tax rate, I see a pretty low 15-16% most years, but the next $100 is taxed at 28%.
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