Understanding the Marginal Tax Rate Formula and Why It’s Important

By Indeed Editorial Team

Updated August 24, 2021 | Published February 4, 2020

Updated August 24, 2021

Published February 4, 2020

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Understanding how much of your income will be taxed and at what rate can help you budget, prioritize and even choose a job. Marginal tax rate is an important term and one that’s simple to understand even if the concept might seem complicated. In this article, we discuss the definition of marginal tax rate, how it differs from other tax rates and how it can affect your income.

What is the marginal tax rate?

The marginal tax rate is the highest level of tax you pay based on your highest tax bracket. Federal income taxes are calculated on a sliding or progressive scale. For income tax, there is no flat percentage owed by each person. Essentially, the more you make, the higher your tax bracket. The higher your tax bracket, the higher the percentage that you're taxed. However, knowing your tax bracket and the percentage at which that money is taxed is only the beginning.

American taxpayers pay between 10% and 37% tax rate. Because the US tax rate is progressive, if you earn above $9,700 of taxable income, your money will be taxed at multiple tax brackets and taxed at different rates. For instance, if you're in the highest tax bracket, a portion of your money will be taxed at each level or tier. However, the marginal tax rate is the highest of those rates, in this case, 37%.

It's important to note that these calculations apply only to your taxable income. The tax brackets do not factor in non-taxable income. Taxable income includes your wages, unemployment and bonuses, capital gains in selling a home or stocks as well as some canceled debts or negotiated payment plans.

Related: Income Tax, Tax Brackets and Deductions Explained

Examples of non-taxable income may include rebates from manufacturers for purchasing certain goods and gifts. To know for certain whether your income is taxable or not, consider consulting a tax professional. Your taxable income is the total of all of your streams of income minus any adjustments or deductions.

Here's an example to help you more clearly understand the marginal tax rate.

If Lee makes $83,000 a year of taxable income, that places Lee as a single head of household in the 22% tax bracket. However, just because Lee's income is in the 22% tax bracket, it does not mean 100% of this income is taxed at 22%. In fact, only the income above $39,475 is taxed at 22%. The income up until $39,475 is taxed at first at a 10% rate for the first $9,700 and then a 12% rate for the remainder.

Because the remainder of the income above $39,475 is taxed at 22%, the higher rate of 22% is Lee's marginal tax rate. And the rate that $43,525 of income will be taxed.

Many investors and self-employed people use the marginal tax rate to consider Investments and bringing on additional work. In Lee's case, Lee is almost at the top of the tax bracket. There is only $1,200 separating Lee from the next level. So if Lee was considering taking on additional work, selling an investment or doing any sort of activity that meant bringing in more than $1,200, Lee's marginal tax rate would increase.

Imagine Lee took on an additional $5,000 worth of work. The first $1,200 would be taxed at the 22% rate, while $3,800 would be taxed at the higher tax bracket rate of 24%. Lee may reconsider that extra work because it means a higher tax bracket. If Lee did take on the work for the additional income, Lee's marginal tax rate is now 24%.

Every year the federal government puts out tax tables that you can find in Form 1040 or on the IRS website.

How is the marginal tax rate different from a flat tax rate?

During presidential election years, you'll often hear candidates talking about replacing the current tax system with a flat tax one for simplification purposes. But what is that exactly?

The marginal tax rate and the progressive system that we currently have allows for each dollar to be taxed at a different rate based on the tax bracket. That way high earners are not paying close to 40% on every dollar of what they earned to the government. It also means people earning lower incomes pay a smaller percentage of taxes on their earnings.

A flat rate, on the other hand, taxes everyone and every dollar of taxable income at the same rate. Social Security and Medicare taxes are taxed at a flat rate. No matter what you earn in the United States, you will pay 6.2% on your taxable income to Social Security up to $132,900. Taxable income in excess of $132,900 is exempt from Social Security. Taxpayers also pay 1.45% of their income to Medicare as a flat tax.

Related: 20 Side Jobs To Generate Additional Income

What are tax brackets?

There are currently seven tax brackets for US taxpayers. The chart below is for a single head of household, and it can help you understand how income falls into each tax bracket.

Single Head of Household Tax Brackets
Tax Percentage Income
10% Up to $9,700
12% $9,701-$39,475
22% $39,376-$84,200
24% $84,201-$160,725
32% $160,726-$204,100
35% $204,101-$510,300
37% $510,301+

Now consider Lee's example and the marginal tax rate of 22% or 24%.

In the first example, Lee made $83,000 of taxable income. This meant the income was taxed at three levels. Using the tax bracket table we can calculate how Lee's income would be taxed. Keep in mind, we rounded up or down to the nearest dollar.

Tax percentage x Income up to max amount = Calculation

10% x $9,700 = $970

12% x $29,775 (which is max level of $39,475-$9,700 already calculated) = $3,573

22% x $43,525 (which is max level of $83,000-$39,475 already calculated) = $9,576

Add all tax levels: $970 + $3,573 + $9,576

Total tax owed on $83,000 income: $14,119

Now, assume Lee wanted that extra end-of-the-year project or new job from which he earned an additional $5,000 of taxable income, for a total of $88,000. That gain would increase Lee's marginal tax rate to 24% on some of that additional taxable income. Lee is now taxed at four percentages as shown below:

Tax percentage x Income up to max amount = Calculation

10% x $9,700 = $970

12% x $29,775 (which is max level of $39,475-$9,700 already calculated) = $3,573

22% x $44,724 (which is max level of $84,200- $39,475 already calculated) = $9,839

24% x $3,800 (which is rest of income level of $88,000-$84,200 already calculated) = $912

Add all tax levels: $970 + $3,573 + $9,839 + $912

Total tax owed on $88,000 income = $15,294

Of the $5,000 additional income, Lee receives around $3,825 after taxes.

Understanding the marginal tax rate and what goes into its calculations is critical to estimating your taxes due. It may also help you decide on whether now is the ideal time to make that job move for the higher salary or to sell something, which might result in capital gains. Before doing so, it is often a good idea to contact a tax professional to speak specifically about your situation.

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