Understanding marginal tax rates is an important part of financial planning. In my first article, I explained how marginal tax rates work, with different levels of income generating varying levels of taxation. The tax bracket for a person’s last dollar of income, also known as a marginal tax bracket, is typically different from their effective rate or total rate of taxation on their overall income. It is important to understand marginal tax rates in order to identify potential tax-saving opportunities.
The way in which tax rates increase as income increases is not linear. Tax rates don’t increase by a consistent amount as you progress through the brackets, as illustrated by the 2022 tax table below.
The chart below shows the seven tax brackets for those married, filing joinly for the 2022 tax year.
As this table illustrates, the higher your income, the more tax you pay on each additional dollar of income. For example, if your income increases from $175,000 to $178,000, the marginal tax rate on that $3,000 increase is still 22%. If your income increases from $175,000 to $180,000, however, a portion of this increase will be taxed at the higher rate in the next tax bracket, which has a 24% marginal tax rate. In this case, the first $3,150 of the $5,000 income differential will be taxed at 22%, and the next $1,850 will be taxed at 24%. This makes the marginal tax brackets progressive in nature and assumes higher wage earners have a greater ability to pay tax than lower wage earners.
Showing this concept in another way, let’s explore the absolute and relative differences between the levels. By absolute, I am referring to the simple arithmetic (one minus the other) difference between any two levels. There is a 2% absolute jump between the 10% and 12% marginal levels (12% - 10% = 2%). However, from the 24% bracket to the next bracket at 32%, there is an 8% absolute difference (32% - 24%). That is a big difference!
The relative difference between marginal tax levels can be viewed as the percentage rate of change between two brackets. Percentage changes are calculated by taking the absolute difference between any two marginal rates and dividing it by the starting, or original rate. The relative difference, therefore, in moving from the 10% to the 12% marginal rate, is the absolute difference (12% - 10% = 2%) divided by the lower rate of 10%, or 20%. This means that you pay 20% more in tax on any income that falls within the 12% marginal tax bracket versus income that falls within the 10% bracket.
Similarly, the absolute percentage difference between the 24% and the 32% brackets is 8% (32% - 24%), while the relative difference is 33% (8% ÷ 24%). This means that income within the 32% marginal tax bracket is taxed 33% more than the income in the 24% tax bracket. The same calculation performed between the 12% and 22% marginal brackets yields a relative percentage difference (increase) of 83% – wow!
Both the absolute and relative (percentage) differences between the various tax brackets are important to understand when applied to financial planning. It becomes critically important in situations where you can manage income and avoid moving into a higher marginal tax bracket. For example, when deciding which month to schedule your retirement date can have significant tax implications. If you retire in the middle of the year, your wage income could be reduced by half, possibly allowing you to avoid higher marginal tax rates.
It is also important to consider marginal tax rates when deciding when to start taking Social Security payments and realizing income from this source. Any decision with the potential to generate or reduce income should include an analysis of the impact on marginal tax rates. Managing, to the extent possible, what income you generate and when can create opportunities to manage the tax you pay.
In fact, there are a myriad of factors and opportunities in financial planning that need to weigh the impact of taxation. In my next article, I discuss some of the key situations where it is important to understand and manage income in the context of marginal tax brackets, including Roth IRA or 401(k) conversions, Medicare premium rates, capital gains taxation, and Social Security income integration. Of course, marginal tax rates are just one of many considerations when determining the optimal solution, including one’s own financial goals. Always be sure to consult with a licensed CPA or qualified financial advisor when evaluating your own situation. The advisors at Blue Chip Partners are skilled in exploring and evaluating these tax considerations in the context of your own, personal financial plan.
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