Tuesday, January 14, 2014

Effective vs. marginal tax rates

Barry Dolowich for the Monterey Herald writes: Question: My wife is considering going back to work now that our children are grown up. I am afraid her earnings will put us in a higher tax bracket. If we enter into a higher tax bracket will we be working for nothing?
Answer: In view of the constant political debates regarding tax rates, the timing of your question could not have been better. Your question illustrates a confusion regarding the tax rate schedule that I frequently encounter among my clients. It almost always makes sense economically to make more money. Only if the tax rates were above 100 percent would it not make sense to earn more money.
Generally, tax preparers look at tax rates from two perspectives, the effective tax rate and the marginal tax rate. The effective tax rate is the total income tax paid divided by your taxable income. The marginal tax rate is the percentage of tax you will pay on the next dollar of income you will earn based upon your current level of taxable income.
The tax rate schedule is progressive. The percentage tax rates rise progressively higher with higher taxable income. However, by earning more, you do not necessarily lose the benefits of the lower tax rate percentage brackets.
For example: If you are in the 25 percent bracket and the next dollar you earn will put you in the 28 percent bracket, you will only pay an additional 3 cents (28 cents less 25 cents) on that dollar by entering the 28 percent bracket. Entering the 28 percent bracket does not mean that all your taxable income will be taxed at 28 percent.
Due to the complexity of the tax laws with many credits and deductions tied to various income levels for phase-outs, there may be certain (but rare) situations whereby earning more money may not be advantageous. If you have a complicated tax return that includes substantial investment income, Social Security benefits, passive activity losses, education credits, etc., you may want to discuss this issue with your tax preparer.


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