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Marginal Tax Rate: Not (Necessarily) The Same As Your Tax Bracket

A reader writes in, asking:

“I wonder if you can write about the ‘marginal tax rate is not necessarily the same thing as your tax bracket’ concept for people who are still working. My spouse and I got caught in this situation for the first time in the tax year 2020 because we will be subjected to the ‘Investment income tax’. We will be addressing this by changing part of our Roth 403b contribution to regular 403b contribution for 2021 and beyond (i.e. to keep our MAGI as a married couple to < $250,000).”

As we’ve discussed many times in prior articles, your marginal tax rate is often higher than just your tax bracket. Most often, I’m discussing that concept in the context of retirees, due to the way Social Security benefits are taxed and the way Medicare premiums are determined. But it can apply to people in their working years as well.

Things that can cause such an effect for people still working would include:

  • The 3.8% net investment income tax, as the reader above noted.
  • Any credit or deduction that phases out based on income level.
  • The way in which long-term capital gains and qualified dividends are taxed. (Other income can push LTCGs/QDs into a different tax treatment.)

Effects of Phase-Outs

As stated above, any deduction or credit that phases out based on your income can cause your marginal tax rate to be something other than just your tax bracket.

A common example would be the American Opportunity Credit, for people paying higher education expenses for somebody in their first 4 years of higher education. For a single person it phases out from $80,000-$90,000 of MAGI, which means that across that $10,000 window of income a $2,500 credit disappears — meaning the marginal tax rate is whatever it would otherwise be, plus 25%! And the credit is per student. For a single person who has, for example, a freshman and a junior in college, their marginal tax rate across that range of income would be whatever it would otherwise be, plus 50%!

For a married couple filing jointly, the phaseout range is from $160,000-$180,000, which means that the increase in marginal tax rate is only half as severe (i.e., an additional 12.5% per eligible student), but it applies across a range of income that is twice as large.

Also of note: beginning in 2021, the Lifetime Learning Credit has the same phaseout range.

Another common example is the premium tax credit for anybody buying insurance on the exchange (which is relevant for self-employed people, people whose employers don’t provide health insurance, and pre-Medicare retirees). The amount of the credit steadily decreases as your “household income” approaches 400% of the federal poverty level, which means that your marginal tax rate is, again, higher than just your tax bracket.

And when your household income passes 400% of the FPL, the premium tax credit disappears entirely, which makes the marginal tax rate extremely high for the $1 of income that pushes you across the threshold. (Important exception: for 2021 and 2022 specifically, the premium tax credit will be allowed to people with income above 400% of the federal poverty level due to American Rescue Plan Act of 2021, passed just last week.)

The student loan interest deduction phases out from $70,000-$85,000 of MAGI ($140,000-$170,000 if married filing jointly). That’s limited to $2,500, and it’s a deduction rather than a credit. And the window of income is broader. So, all of those effects combined means that the effect of such is not so dramatic, but it’s still one more thing causing marginal tax rate to be greater than the applicable tax bracket.

The list goes on and on — child tax credit, child and dependent care credit, earned income credit, retirement savings contribution credit. If it phases out based on your income, it can cause your marginal tax rate to be higher than just your tax bracket.

Long-Term Capital Gains and Qualified Dividends

Long-term capital gains and qualified dividends are taxed at a lower rate than ordinary income. Rather than being taxed according to your tax bracket, they are taxed at the following rates:

  • 0% tax rate if they fall below $80,800 of taxable income if married filing jointly, $54,100 if head of household, or $40,400 if filing as single or married filing separately.
  • 15% tax rate if they fall above the 0% threshold but below $501,600 if married filing jointly, $473,750 if head of household, $445,850 if single, or $250,800 if married filing separately.
  • 20% tax rate if they fall above the 15% threshold.

Example: Bob is single. Excluding his qualified dividends and long-term capital gains, his taxable income for 2021 is $38,000. He also has $4,000 of long-term capital gains. His first $2,400 of long-term capital gains (i.e., those that fit under the $40,400 threshold) will be taxed at a 0% rate, and the remaining $1,600 will be taxed at a 15% rate.

But here’s where things get tricky. With total taxable income of $42,000, Bob is in the 22% tax bracket. But if his ordinary income increases by $1,000, his income tax for the year will increase by $270 (i.e., a 27% marginal tax rate).

That’s because the 12% bracket extends up to taxable income of $40,525. And, excluding LTCGs, Bob’s taxable income is below that threshold. However, his taxable income excluding LTCGs is now $39,000 rather than $38,000. So we have 12% regular income tax on this $1,000 of additional income (i.e., $120 of tax).

But there’s another effect going on as well. There is now only $1,400 of space for LTCGs before hitting the $40,400 threshold. That is, this $1,000 of additional ordinary income is also causing another $1,000 of his long-term capital gains to be above the $40,400 threshold and therefore taxed at a 15% rate, so that causes another $150 of income tax.

So we have $120 + $150 = $270 total dollars of tax being caused by this $1,000 of income. A 27% marginal tax rate, despite a taxable income that is in the 22% bracket.

In Summary

Even for me — having written about this concept for years — these effects are not usually intuitive.

This is why I often discourage people from trying to do tax projections using nothing but Excel. It’s hard to account for all of the different thresholds. (This is especially true when we remember that the thresholds in question apply to different income calculations! Some look at taxable income, the premium tax credit looks at “household income,” and many look at modified adjusted gross income — which itself has several different definitions.) Much better, in my opinion, to use actual tax software that automatically accounts for everything.

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"
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