Determining Your Marginal Tax Rate

From Mike Piper & The Oblivious Investor we read the following Question & Answer:
“I’m a recent grad, with my first real job and am learning about taxes for the first time. I understand that knowing my ‘marginal tax rate’ is very important for many decisions. But from what you’ve written recently, it sounds like there’s a lot more to it than just tax brackets, correct? And do you have any tips for determining what my actual marginal tax rate is other than just looking at my tax bracket?”

You’re right that there are many factors that can cause your marginal tax rate to be something other than just the tax bracket you’re in. For example (and, to be clear, this is not an exhaustive list):

• Once your adjusted gross income exceeds (for 2013) $29,500 if single or $59,000 if married filing jointly, you lose eligibility for the Retirement Savings Contribution Credit,
• Once your “household income” exceeds 400% of the federal poverty level, you lose eligibility for the Affordable Care Act subsidies (tax credits) for people purchasing health insurance via one of the new exchanges,
• Once your adjusted gross income exceeds (for 2013) $250,000 if single or $300,000 if married filing jointly, the personal exemption phaseout and limitation on itemized deductions come into play,
• Once your “combined income” exceeds $25,000 ($32,000 if married filing jointly), Social Security benefits begin to be (partially) taxable,
• Qualified dividends and long-term capital gains go from being untaxed to being taxed at 15% once they fall into the 25% (or greater) tax bracket, and they’re taxed at 20% if they fall into the new 39.6% tax bracket, and
• Once your modified adjusted gross income exceeds $200,000 if single or $250,000 if married filing jointly, the 3.8% tax on net investment income comes into play.

In other words, there are a number of taxes that appear and tax credits/deductions that disappear as your income crosses various thresholds or travels through certain ranges, thereby causing your marginal tax rate to be higher than just your tax bracket as your income travels through those ranges or across those thresholds.

Unfortunately, this is not the sort of thing that lends itself to fast and easy modeling in a spreadsheet, given that these various calculations aren’t all based on the same measurement of income. That is, some are based on taxable income. Some are based on adjusted gross income. Some are based on varying definitions of modified adjusted gross income. One is based on “combined income.” And one is based on “household income.”

One of the best methods for figuring out your marginal tax rate is to plug your information into your favorite tax prep software and try fiddling with the numbers a bit. For example, try bumping your income up or down in increments of $500 or $1,000 and see if your total tax changes by something other than just your tax bracket multiplied by the change in income.

Unfortunately, even this isn’t perfect, because tax laws change from year to year. For example, plugging your current information into a 2012 edition of a tax preparation product will not necessarily give you your correct marginal tax rate for 2013, given that the software doesn’t apply the various new rules that have come into effect in 2013 (e.g., the 3.8% net investment income tax). So to be really sure about your analysis, you need to keep abreast of tax law changes each year so that, if necessary, you can make manual adjustments to what the software is telling you.